Global banks may be adopting a 'window dressing' technique used by Lehman Brothers before it went bankrupt

Paul Hawthorne/Getty ImagesBanks have been accused of ‘window dressing’ for the regulators.
  • A report by the Bank for International Settlements shows banks are exploiting loopholes to adhere to stricter leverage ratios .
  • The BIS said evidence of ‘window-dressing’ in the repurchase agreements (repo) market is “material”, with European banks the biggest culprits.
  • The repo market was used by Lehman Brothers to cover up losses at quarter-end, before its bankruptcy sparked the global financial crisis.

The Bank for International Settlements has released its annual economic report, and one of the findings highlights that global banks are unceasingly turning to an accounting trick that was popular before the financial crisis.

The strategy concerns repurchase agreements, known as repos. Repo markets are a mechanism by which banks can obtain short-term funding using their existing assets as collateral.

They can also on-lend the funds received in a process called reverse-repo, which can then be used as the basis for further short-term borrowing.

The end result is that repo markets allow banks to increase the amount of leverage they have, relative to their underlying assets.

That can be a problem when it comes adhering to regulatory standards, particularly since 2015 when the BIS introduced stricter standards around leverage ratios.

In order to meet reporting requirements, the banks unwind some of their reverse-repo trades, which they use to pay back repo debts.

That gives the appearance of tighter leverage ratios when the banks need it — at the end of each quarter. Then leverage picks up again as the next quarter begins, a practice the BIS called “window dressing”.

“The data indicate that window-dressing in repo markets is material,” BIS said, noting the practice is particularity prevalent for banks in the euro area.

It’s less so for banks in the US and UK because they have to use averages for the period, rather than a specific amount at quarter-end.

This chart clearly illustrates how leverage ratios for repo funding in US dollars fluctuates wildly for Eurozone banks, compared to a much smoother average for other regions:

Source: Bank for International Settlements

“Since early 2015, with the beginning of Basel III leverage ratio disclosure, the amplitude of swings in euro area banks’ repo volumes has been rising – with total contractions by major banks up from about $US35 billion to more than $US145 billion at year-ends,” the BIS said.

In the fallout from the collapse of Lehman Brothers in 2008 — a central precursor to the global financial crisis — reports emerged of the rampant use of repo loans by the bank in order to cover up losses in each reporting quarter.

Internal emails revealed Lehman execs referred to repo trades as “accounting gimmick” and “another drug we’re on.”

In order to combat the risks stemming from the use of repo loans as a window-dressing technique, the BIS encouraged stricter regulatory standards across all jurisdictions.

“Options include aligning national implementation on the basis of period averages, stepping up supervisory responses, and requiring banks to disclose both metrics to enhance market discipline.”

You can read more about the the use of repo loans in the BIS’ Annual Economic Report here.

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