This article was written by Richard Horswill. All views and opinions expressed are strictly his own.
The Great Financial Crisis (GFC) of 2008 was driven by an interbank Repo market failure. What does that mean? Firstly we need to understand what a Repo is.
Repo – A practice in which a bank or other financial institution buys securities (collateral) with the proviso that the seller must repurchase the same securities for an agreed-upon price on a certain day. Investors and financial institutions do this in order to raise short-term capital. A repo is also called a repurchase agreement. Thus, a repurchase agreement can be thought of as a collateralised loan. The lender provides cash to the borrower in exchange for a security, which acts as collateral. Large institutional investors such as money market mutual funds lend money to financial institutions such as investment banks, either in exchange for (or secured by) collateral, such as Government bonds and mortgage-backed securities held by the borrower financial institution.
The monetary panic of 2008 and the global banking crisis that ensued created the circumstance that we understand as a credit crunch. This is purely the withdrawal of credit from the economy. The withdrawal of credit/wholesale funding through the Repo market was based upon the quality of the collateral being offered and thus the rejection of that collateral. The subsequent run on the repo market, in which funding for investment banks was either unavailable or at very high interest rates, was driven by bad collateral in the form of subprime mortgage securities. The consequences meant the banks did not trust each other and the whole system just stopped functioning.
The bailout mechanism for the crisis in order to restart the Repo market and bring trust back to the interbank short term lending system was essentially to provide trillions of taxpayer dollars to cover the losses of the global banks and financial institutions transferring the burden from private hands to sovereign ones.
The question surrounding a potential replay of the 2008 credit crunch relates to whether the current collateral being traded within the Repo market is firstly trusted but also whether there is enough collateral in the market that would be accepted by the market participants. These two factors will have significant effects on Repo conditions. A pertinent factor to the above relates to the actions that are being taken by central banks, which represent the current tightening of financial conditions by raising interest rates and reducing their balance sheets via QT (quantitative tightening).
Higher rates driven by Central bank policy immediately undermine existing collateral which is worth less than new collateral being issued as yields have been suddenly and significantly increased on short term debt/bonds. This immediately pushes up overnight funding costs. Counter parties with cash will require a higher rate to counteract the lower quality collateral being offered. This acts to either reduce the amount of available collateral meaning more must be offered or the over night rate must increase, potentially threatening stability in the market. In this scenario the central bank steps in to provide the liquidity needed. The central bank buys securities from eligible counterparties, providing liquidity with the agreement to sell back the securities at a later date. This facility is effectively an overnight QE process driving rates back down in order to stabilise the market. How ironic that the central bank could have to step in to resolve issues created by the rate increases and the QT on maturing bonds.
Since the 2008 GFC, global banks have preferred to invest in safe and liquid assets in the form of Government debt and mega cap corporations rather than small caps and the public. This represents a significant change in the risk averse nature of banking following the blowout. Thus, a less thought of headwind that could be very relevant to Repo markets relates directly to the perceived quality of Government bonds as collateral. For example, the current structure of European debt markets has come under pressure as the quality of German debt and Italian debt are clearly not the same, although the European Central Bank has seemingly been able to spin a plan to protect weaker bonds in the Eurozone via an anti-fragmentation tool which is in effect a fudge. Will the markets believe that central banks can control perceptions? Or will offered collateral in the form of certain Government debt come under pressure. With sovereign debt loads increasing exponentially following the global pandemic and now a global energy crisis, deficit spending could tip markets the wrong way as confidence leaks from the system.
A strong dollar also puts pressure on sovereigns as dollar funding costs increase on dollar denominated debt outside of the United States. Debt servicing becomes problematic. A good example of a recent Sovereign debt crisis is Sri Lanka. They are not alone and other possible Sovereign debt defaults could well place stress on the global wholesale funding system, particularly in the form of perceived risky collateral.
Signs as to whether another Repo failure may occur as a result of collateral trust and shortage could well be as simple as the message that the yield curve inversion sends to the market, which effectively disagrees with central bank policy which seems on the face of it dogmatic and likely to continue until something breaks. Thus, recognising potential risk existing in all markets including the underlying structure of wholesale funding markets is important. Actions taken by financial authorities to tackle supply shocks driven by pandemics and war ultimately put stress on an already beleaguered global monetary system, reeling with massive debt burdens, that has struggled to find consistent growth since 2008. Higher funding costs hit everyone and although it is believed that systemically important global banks are well insulated to tackle another crisis, the complexity of the system along with the synchronised nature of global capital markets could well be hiding a nasty surprise around the corner. Ultimately, we cannot predict the future but the past can provide clues that assist with assessing probabilities. Since GFC 2008 markets have remained volatile, inconsistent, untrustworthy and generally running on fumes. Another Repo mishap could well instigate a swift reversal in the current central bank playbook to protect global markets, leading them to ignore the inflation fighting mantra for one that again provides ZIRP/NIRP (zero/negative interest rate policy) bailouts for banks and big business at the behest of maintaining the status quo but also at the expense of continued societal inequality . So much for central bank credibility if this occurs! We shall see.