Saturday, 12 October 2013

The ECB, repos and financial integration

Before 2008, it was fashionable for European institutions to exalt the virtues of financial integration. Very small yield differentials between German and Greek government bond markets were approvingly cited as evidence that the Eurozone project of financial integration was progressing at rapid speed, at least in wholesale money and securities markets. Now European institutions routinely blame financial markets for failing to notice default/credit risk in sovereign bond markets.

Yet the evolution of the repo market - where financial institutions exchange collateral for cash, with a promise to reverse that transaction at a later date - suggests that European institutions encouraged markets to disregard fundamental differences. The  European Commission's 2002 Financial Collateral Directive was premised on the idea that repo integration would increase cross-border holdings of financial assets if repo market players could use these assets as repo collateral.

The ECB also got involved, through its collateral framework:

…the way market participants perceive the different national characteristics of securities accepted as collateral in repo transactions constitutes one aspect of the fragmentation of the euro area repo market. For instance, given the different credit ratings of euro area governments, there might be differences in the terms of repo transactions (i.e. repo rate, haircut) with government securities as collateral, depending on the country. The same applies to the differences in the liquidity of government securities. Market integration would benefit from the extension of a euro GC approach, enabling participants to put securities with similar, although not the same, characteristics in the same basket. Eurosystem collateralised operations are an example of this approach. (ECB, 2002: 68

The ECB equated full repo integration with sovereign bond market integration since the latter provided the bulk of collateral for private repo transactions. It suggested that repo markets should, when integrated perfectly, treat government bonds of any Member States as functionally equivalent collateral. To achieve this, the ECB proposed to combine public and private efforts. 

Thus, private repo actors were encouraged to institutionalize a euro GC repo basket. In GC - or General Collateral - repos, the counterparties agree on a set of securities that are equivalent as collateral in terms or quality and liquidity, and accept any or all of those securities to collateralize repo transactions. For example, in a euro GC basket, a bank could borrow EUR 100 cash on the same terms whether it posted EUR 100 German bonds (at market value), or EUR 100 Belgian bonds, or a combination of the two. If the basket was extended to include all Eurozone sovereigns, it would encourage financial institutions to become ‘truly’ European in their portfolio allocations, abandoning preferences for the home sovereign.
Demand for non-home sovereign would improve the liquidity of government bond markets across Europe, accelerating integration. 

On its part, the ECB set an example through its collateral framework. In repos collateralized with government bonds, the ECB applied the same haircuts and repo rates regardless of whether the bond was AAA (Germany) or A rated (Greek).  The ECB created its own euro GC basket for Eurozone sovereigns, and hoped that markets would follow suit (which they did, for example through Eurex's GC Pooling).

Buiter and Sibert (2005) provided a sharp criticism of the ECB collateral framework. The ECB’s collateral decisions were partly responsible for a narrowing of the sovereign bond spreads across the Eurozone. When the ECB bundled together German and Greek sovereign bonds in the same liquidity category, it provided a subsidy to lower-rated sovereigns and encouraged private repo actors to ignore default risk. Through its collateral policies, the ECB signaled to markets that it believed all European sovereigns were of equal financial standing. The technicalities of open market operations masked political decisions to energize financial integration at the expense of fiscal discipline in Europe.

The ECB's defense to such arguments rested on the risk management framework. Its repo operations would not influence market valuations of government bonds since it used, like private repo actors, mark to market and daily margin calls, its collateral policies accommodated the market pricing of government debt. If markets distrusted a particular European government, then the market value of its bonds would fall, and the ECB would require more collateral on the loans secured with those government bonds. 

Now we know that mark-to-market/margin calls may sharpen fire sales and liquidity spirals in repo-dependent financial systems. But somehow the ECB has emerged out the European crisis without recognizing any responsibility for pushing pre-crisis financial integration without considering the new types of systemic risk generated through repo markets, or the possible destabilizing consequences of its collateral management framework for European repo markets: 

The financial crisis which erupted in 2007 has fragmented the GC repo market in eurozone government bonds by causing investors to differentiate between the credit of issuers in core and peripheral eurozone countries. There is consequently a German GC market, a French GC market and so on, but there is no longer a eurozone GC market, except for one-day repos, where credit risk is minimal.  (European Repo Council, 2013).

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