Fitch Warns of Repo Crisis for Banks

Financing through repurchase agreements (repos) is at a serious risk for banks in the event of substantial volatility in the bond market, warns Fitch Ratings.

According to a report published by the U.S. rating organisation, characteristics of corporate bond collateral could raise risks of fire sales, or the forced unwinding of collateral in repo-fund trades during times of market turmoil.

“Such risk aversion could limit the ability of dealers to finance securities in the repo market. Cash investors such as MMFs (money market funds) could also be forced to sell collateral in the event of a dealer default,” Fitch Ratings says.

It also highlighted that corporate bonds with maturities of one year or more carry greater interest rate risk, and therefore would be more difficult to sell in period of market dislocation.

Corporate bonds are used by most banks as collateral for short term repo loans, however in a stressed environment; the study says that investors will opt to not renew agreements with banks, requiring them to return the cash at a time when they may not have it.

In a repo, banks will pledge collateral in exchange for cash from investors. Total corporate bond tri-party repo collateral averaged approximately $75 billion last year.

The study says: “Forced selling of even a small fraction of that amount could accelerate price pressure during periods of market stress.”