Highlights and Implications of Global Regulatory Reforms for Enhanced Repo Market Stability[17-09]
In Seok Baek
The date
11 May 2017
Capital and Financial Markets
Since the global financial crisis, repo market stability has attracted growing attention domestically and internationally. Unlike the expectations regulators and market participants had about repo transactions’ stability, the repo market served as one of the culprits behind financial unrest in the US and in Europe. In particular, the US repo market was the main contributor to the spread and deepening of the financial crisis. This triggered global regulatory authorities to concentrate their efforts on reducing financial institutions’ reliance on repo transactions and in improving repo market stability.  
In Korea, the government persistently strived for facilitating the repo market as part of attempts to help financial institutions raise capital stably and the money market reduce its systemic risk. As a result, the tri-party market has gained steam again and risen as a core element of the money market. However, Korea’s repo market still has shortfalls in terms of qualitative growth. As Korean policy authorities and market participants are required to make endeavors for qualitative development and stability in the repo market, global regulatory reforms designed on the initiative of the US and Europe is expected to be a key determinant for Korea’s repo market development. Although global regulatory reforms include some provisions that may help improve the stability of the Korean market, some other provisions appear to be inappropriate for Korea. Hence, it is important to assess the impacts of the reform on Korea’s repo market first, and to consider making aggressive changes on the provisions that seem inappropriate for Korea’s market features. 
Since the outbreak of the global financial crisis, global regulatory authorities have driven many regulatory actions designed to prevent the recurrence of market disruptions that hit the US and European repo markets during the crisis. The global financial crisis revealed the following problems of the repo market. First, overconfidence in the stability of repo transactions led to over-reliance on overnight repos, which put many financial institutions to a liquidity crisis. Second, the excessive leverage accumulated via repo transactions in the financial system triggered an abrupt deleveraging process, during which collateral securities were sold at fire sale prices, amplifying the crisis further. Third, as repo haircuts showed excessive procyclicality with an abrupt rise in haircuts on illiquid collateral securities, financial institutions’ deleveraging and liquidity crisis deepened.
From the regulatory standpoint, the lesson of the global financial crisis lies in that the Basel framework, prudential regulation of banks and securities firms within bank holding companies (banks, hereinafter), failed to properly monitor banks’ liquidity crisis and excessive leverage. To tackle the issue, global regulatory authorities carried out a major overhaul on the previous Basel framework to introduce Basel III with liquidity and leverage ratio regulations at the central part. Furthermore, the FSB has pushed for minimum haircut floors for banks and non-bank financial institutions with the aim for controlling the procyclicality of repo haircuts.  
The Basel Committee introduced a new liquidity regulation that consists of the liquidity coverage ratio (LCR) governing short-term liquidity, and the net stable funding ratio (NSFR) dealing with long-term liquidity.
The LCR proposes to mandate banks to hold a proper level of high-quality liquid assets to meet their liquidity needs for a 30-day liquidity stress scenario. Regarding repo transactions, the LCR applies differentiated run-off rates across collateral securities banks use for repo transactions, trying to ensure that banks hold high-quality liquid assets that correspond to the run-off. However, it is viewed that the LCR failed to fully reflect past crisis experience because it applies a way low run-off rate on repos backed by government debt. 
The NSFR, long-term liquidity regulation, was introduced to improve the structural stability of bank funding by reducing banks’ reliance on short-term funding sources and curbing excessive maturity transformation. The NSFR standard induces a bank, when funding a less liquid asset, to meet a higher ratio of available stable funding unlikely to be withdrawn in one year to required stable funding. In terms of repo transactions, the NSFR regulation induces a bank to reduce its funding via super-short repo transactions such as overnight repos to another financial institution. Also, it produces a maturity-lengthening effect when a bank uses a repo transaction to finance securities it holds. Although it curbs excessive maturity transformation of banks using repos and thus contributes to market stability, it at the same time could excessively rein in repos’ positive functions. Hence, Korea should carefully review whether to introduce some part of the NSFR or not.
To supplement the existing risk-based capital requirements and to prevent the leverage from accumulating excessively in the banking system, the Basel Committee introduced leverage ratio regulation, which is non-risk-based capital requirements. This led to a substantial reduction in repo transactions in the US and European banks.
Besides Basel III, the FSB has pushed for the minimum haircuts across collateral securities in order to curb repo haircuts’ procyclicality. In addition, the FSB has been working on the qualitative standard on the practice of how market participants determine haircuts.
This study carried out a comparison of Korea’s repo market to the US and European repo markets, and drew the following challenges for Korea’s repo market stability. First, from the market structure perspective, large securities firms and banks should play larger roles in Korea’s repo market. In the US and Europe, banks and large securities firms function as a repo dealer, intermediating repo transactions between investors and end borrowers. Compared to other financial institutions, large securities firms and banks in Korea have superb capabilities for absorbing shocks from a crisis and managing borrowers’ credit risk and collateral risk. Hence, those two types of players should induce money to be more efficiently allocated in the repo market by intermediating repo transactions between small- to medium-sized financial institutions. 
Second, from the standpoint of practice, it is necessary to enhance the economic function of haircuts, one of the inherent features of repo transactions. In the US and Europe, haircuts are wildly differentiated across collateral risk and counterparty credit risk, whereas a same haircut is used regardless of transaction counterparties and collateral securities in Korea. To secure repo market stability during times of financial unrest, lenders should use haircuts at normal ties to comprehensively manage borrowers’ credit risk as well as collateral risk.
Third, policy authorities need to induce diversified maturity structures in Korea’s repo market. Korea’s reliance on overnight repos exceeds that of the US right before the global financial crisis. When overnight transactions become prevalent in the repo market, this is likely to amplify market instability during financial unrest. 
A suitability analysis of global regulatory reforms revealed the followings. First and foremost, Korean regulatory authorities should look at the NSFR that will take effect in 2018 to analyze the content that seems inappropriate for the Korean market. In the proposed NSFR standard in Basel, the followings are forecast to have grave impacts on not only banks, but also the functioning of the overall repo market.
First, under the NFSF standard, when a bank provides funds to other banks, securities firms, etc. via reverse repos maturing less than six months, 10% or 15% of the amount of funding should have maturities of one year or longer, depending on how liquid the collateral is. Such a requirement seems overly excessive, and if introduced in Korea, will possibly shrink Korean banks’ repo transactions. Behind the NSFR within the Basel framework lies in the intention to reduce the funding from a large securities firm in a bank holding group to hedge funds via reverse repo transactions. However, this segment accounts for only a small proportion in Korea’s repo market. Hence, it is desirable for Korea to substantially ease or delete the NSFR in the domestic market.
Second, the NSFR standard requires a bank to hold stable funding sources for 5% to 85% of securities it holds. If applied to the repo market, a bank, when financing its government debt position by selling repos, can fund 95% of the sale amount with overnight transactions or other funding sources maturing less than six months. But the remaining 5% should have maturities with one year or longer. By any measure, forcing a one-year maturity or longer when selling repos backed by government debt seems excessive.
Another line of the Basel standard, the LCR regulation, has been applied to banks in Korea since 2015. Due to its lax terms, the LCR regulation is clearly limited in its ability to improve banks’ short-0term liquidity resilience during a financial crisis. Korean banks trade their reserves via repo transactions, but their reliance on repos is still low. Hence, there is little need for Korea to apply a tough regulation in this area ahead of the US or Europe. Korean regulatory authorities should better adopt the LCR as it is in their monitoring on Korean banks’ repo transactions, while taking the LCR’s limitation in enhancing banks’ short-term resilience into account.
Next, the minimum haircut regulation proposed by the FSB seems undesirable for Korea. Given that the haircut is the innate market nature of repo transactions, forcing the level of haircuts may distort market functions. However, Korea should positively consider introducing the FSB’s proposal for regulatory authorities to set out the qualitative guidelines for haircuts. The government should set out qualitative guidelines on haircuts, and make sure large financial institutions to formulate and comply with their internal regulation based on the guidelines.  
Lastly, I propose Korea’s policy direction moving in the direction of lengthening maturities in the repo market. Overnight repos account for an excessively large proportion in Korea’s repo transactions, especially those among securities firms. To reduce overreliance on overnight repos, the government unveiled policy measures for facilitating term repos in September 2016. Rather than placing a direct liquidity requirement, the measures focus on policy actions to make term repos trade more conveniently. They will be implemented in 2017. U.S. and European regulators affirmed their intention to apply another liquidity regulation on independent securities firms, that is as stringent as the Basel’s liquidity standard, but no concrete action plans have been announced yet. Hence, rather than directly applying the liquidity regulation on Korean securities firms in the short run, it would be better to carefully observe the effect of the repo facilitating policy. Meanwhile, Korea should prepare its own liquidity management tool in the case that excessive reliance on overnight transactions remains among some financial institutions.