The Fed Plots The Next Disastrous GSE


The Federal Reserve is planning to create a government sponsored entity to act as a central clearing house and guarantor of the overnight lending market used by investment banks to fund operations, the Financial Times reports.

The idea is that the government would create some kind of overnight repurchase market ‘utility’ that would act as the go-between for lenders such as money market funds and borrowers such as investment banks. That’s a role currently played by private banks, principally JP Morgan Chase and Bank of New York Mellon.

Why replace the private system for the overnight repurchase market? The Fed’s plans were reportedly sparked by concerns that the way the system is currently structured exacerbated the crisis leading up to and following the collapse of Lehman Brothers.

From the FT:

In the repo markets, borrowers, such as banks, pledge collateral in return for overnight loans from lenders, such as money market funds.

The clearing banks stand between the parties, providing services such as valuing the collateral and advancing cash during the hours when trades are being made and unwound.

Fed officials fear this arrangement puts the clearing banks in a difficult position in a crisis. As the value of the securities falls, clearing banks have an obligation to demand more collateral to avoid losses. But in doing so, they could destabilise a rival.

This makes me nervous. If I’m reading this correctly, The Repo Utility—as we’ll call it—would create more stability for investment banks by reducing market discipline. Lenders would know that a government backed entity stood behind the overnight loan market, which would reduce lender vigilance. Investment banks would be assured of liquidity, taking away any incentive to reduce dependence on the overnight repo markets. In short, the risky structure would be kept in place but much of the risk would be transferred to taxpayers.

This has obvious moral hazard risks, with parties on both sides of the repo market becoming less sensitive to credit risk. What’s more, it means that market-based risk modelling that banks should use to control their behaviour would become more difficult because the overnight credit markets would no longer quickly show clear signals of distress.

In short, it sure sounds like the Fed is adding systemic risk rather than reducing it.

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