How much does repo encumber collateral?

The issue

The encumbrance of banks’ assets has become an issue of growing concern to regulators. Banks have increasingly resorted to secured funding in the wake of the financial crisis and as unsecured funding has become more expensive and generally scarce, while investors have increasingly preferred secured assets in order to mitigate heightened counterparty credit risk.

The incidence of asset encumbrance has been widened by new regulatory requirements for greater collateralisation of credit and liquidity risks under Basel III (and in Europe, Solvency II), the mandatory central clearing of standardised OTC derivatives, the compulsory imposition of initial margins on collateral and stricter collateralisation standards for CCPs.

And asset encumbrance is fostered by the implicit public guarantees against credit risk that have been provided in the past to too-big-to-fail banks and the guarantees against liquidity risk are still being provided by central banks. Currently, the main source of asset encumbrance in a number of European countries is the exceptional liquidity assistance provided by the European Central Bank (ECB).

The ESRB has calculated that the median asset encumbrance of 28 large European banks (encumbered assets/total assets, with repos netted against reverse repos) increased from 7% in 2007 to 27% by 2011, although the degree of asset encumbrance varies very widely, even within Europe, between countries and between institutions.[1]

What is asset encumbrance?

Legally-speaking, asset encumbrance is a claim against a property by another party. In finance, such claims have traditionally taken the form of security interests, such as pledges, given on assets by a borrower to a lender.
In other words, giving collateral encumbers assets. If the borrower defaults, the secured lender has the right to liquidate the asset/collateral and recover his cash. He is therefore given preference over unsecured creditors, who are said to be ‘structurally subordinated’ in terms of their priority in bankruptcy.

In measuring encumbrance, regulators include, not just assets as recorded on the balance sheet, but also financial instruments received as collateral and not recorded on the balance sheet of the holder (because the asset has been pledged or because, as in the case of a repo, because the collateral asset remains on the balance sheet of the giver in order to reflect the fact that the risk and return on the asset has been restored to the give). The EU Capital Requirement Regulation (CRR) says, ‘… an asset is considered encumbered if it has been pledged or if it is subject to any form of arrangement to secure, collateralise or credit enhance any transaction from which it cannot be freely withdrawn’. Thus, the European Banking Authority (EBA) has defined asset encumbrance as:

What problems are created by asset encumbrance?

The main focus of regulatory concern about asset encumbrance is on: the impact on the credit risk of unsecured depositors; the problems created for deposit insurance/guarantee schemes and bail-ins; and increased liquidity risk on secured lenders.

Encumbrance reduces the assets available to the liquidator in the event of a default by a bank and therefore the recovery rate of its depositors and other unsecured bank creditors. As a result, wider asset encumbrance forces depositors to rely on insurance and guarantee schemes, usually to the cost of the public. The risk to unsecured investors from wider asset encumbrance may also make long-term unsecured debt too expensive for banks to issue, thereby limiting the quantity of these assets available for ‘bail-ins’ under emerging recovery and resolution regimes, and exposing tax-payers once again to the cost of rescuing failing banks.

Regulators would also like to see sufficient unencumbered assets remaining on banks’ balance sheets to strengthen their resilience by providing a liquidity buffer against roll-over risk in difficult market conditions. In stressed markets, it is expected that unsecured funding would be tightly constrained given the likely shift in investor preferences towards secured assets. A buffer of unencumbered assets could be sold or repoed out (if necessary to a central bank).

In addition, a liquidity buffer of unencumbered assets would help protect against contingent asset encumbrance. Collateral makes a bank’s liquidity profile sensitive to changes in the market value of that collateral. Whenever the value of collateral decreases, a borrower is usually called upon to provide additional collateral in the form of a margin. New borrowing will also attract higher haircuts on collateral. Banks may also face unexpected future liquidity needs, such as calls on committed credit lines. In addition, there is the risk of losses being realised during liquidation of collateral after a default, which would further reduce the recovery rate for secured lenders. And as these contingencies are realised during financial stress, worsening asset encumbrance may pro-cyclically amplify the stress in a way that is non-linear. The problem is more acute at higher levels of asset encumbrance.

Asset encumbrance has traditionally been associated with covered bonds in the capital market but regulators are now looking at encumbrance in the short-term funding markets, in particular, at the role of repo.

At this stage, regulatory proposals are limited to the monitoring of asset encumbrance and requirements on banks to be more transparent in their reporting, so that unsecured creditors can more accurately assess the risk posed to their recovery rate by asset encumbrance. However, some countries impose prudential limits on the issuance of covered bonds in order to contain asset encumbrance and others may follow.

What is the impact on repo on asset encumbrance?

One concern about the current asset encumbrance monitoring proposals, which have been elaborated in Europe by the EBA, is that they try to add apples to oranges. By measuring encumbrance simply in terms of the nominal value of collateral, they incorrectly assume one unit of collateral has the same economic impact regardless of the instrument to which it is attached.

Consider collateral pledged by an institution to cover the exposure on a derivatives contract. The entire amount of collateral so pledged is encumbered. Unsecured creditors of the pledgor do not have access to those assets in a bankruptcy.

Now, consider a repo. Take a simple example. Bank A has cash assets of 10 funded with liabilities in the form of 5 of equity capital and 5 of unsecured deposits. Its balance sheet looks thus:

assets

liabilities

cash

10

deposits

5

capital

5

total

10

total

10

Assume Bank A invests all the cash in bonds worth 10. Its balance sheet is little changed.

assets

liabilities

bonds

10

deposits

5

capital

5

total

10

total

10

Next, Bank A repos out all the bonds to Bank B in exchange for cash of 9.8 (there is a 2% haircut). Bank A’s balance sheet expands.[2]

assets

liabilities

bonds

10

deposits

5

repo cash

9.8

capital

5

repo

9.8

total

19.8

total

19.8

Bank A then uses the cash from the repo to buy 9.8 more in bonds.

assets

liabilities

bonds

10

deposits

5

bond collateral

9.8

capital

5

repo

9.8

total

19.8

total

19.8

How encumbered is Bank A? The current monitoring standards published by the EBA imply that, of the 19.8 of bonds held by Bank A as assets, 10 have been encumbered because they represent bonds held as repo collateral by Bank B. But what if we measure asset encumbrance in terms of the effect of the repo on the rate of recovery of the unsecured depositors?

In the event of a default by Bank A, the 10 ‘encumbered’ bond assets would be set off against the 9.8 in cash owed to Bank B. This would leave Bank A’s liquidator with an unsecured claim of 0.2 against Bank B plus the second quantity of 9.8 of bonds that it purchased. If Bank B pays the unsecured claim of 0.2, Bank A’s liquidator should be able to sell off the remaining 10 in bonds and repay unsecured depositors.

The impact of the repo on the rate of recovery of unsecured depositors is limited to two amounts:

  • The haircut given in repos. In the example above, Bank B may also default and so Bank A’s liquidator may not recover the haircut of 0.2.
  • If the bonds sold in the repo have credit risk and liquidity risk (compared to cash, which we assume is risk-free), then reductions in the value of the bonds due to fluctuations in their price will generate margin calls on Bank A. In the event that Bank A defaults and the bonds have to be sold, reductions in the value of the bonds due to fluctuations in their price may be realised as a loss. Margin calls and liquidation losses can be seen as contingent encumbrance, since they represent potential claims on unencumbered assets.

In other words, the asset encumbrance due to a repo is, at worst, a marginal, partly contingent, amount that, on the one hand, depends on whether haircuts are given and, on the other hand, reflect the quality of the assets sold as collateral. In the example, asset encumbrance is a small percentage of 9.8.

Other issues

The regulatory argument about limiting asset encumbrance to provide a buffer in order to strengthen the resilience of banks against market illiquidity is an example of the current tendency of regulators to simultaneously apply direct and indirect measures to control risk, with no regard to the combined effect. In this case, the EBA is using regulation of asset encumbrance to reinforce the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR). But if the LCR and NSFR are properly calibrated, what purpose is served by uncertain supplementary measures, other than to distort the market and possibly generate unexpected consequences?

It is also not clear how much resilience will be improved by a larger buffer of unencumbered assets. This depends critically on the creditworthiness of the borrower. The primary focus of repo is on counterparty credit risk. Therefore, institutions who are deemed uncreditworthy do not find it easy to do repo, even if they have unencumbered liquid assets available to repo out. Of course, the central bank may be less discriminating!

Regulators have argued that asset encumbrance needs to be limited, not only to provide a liquidity buffer to banks, but also to prevent the cost of unsecured credit being raised so far by the risk to unsecured creditors posed by asset encumbrance that unsecured wholesale funding is crowded-out by secured funding.[3] However, economic theory would suggest that, when encumbrance increases, unsecured creditors should demand a higher rate of return (an argument for transparency). If prices for secured and unsecured financing are able to adjust, and banks and their providers of funding can freely choose quantities, unsecured creditors can accept higher risk for higher return. Bank stability depends on the overall cost of funding, not the cost of any one component; higher costs of unsecured funding may be more than offset by lower costs of secured funding.[4]

Another concern over current regulatory thinking on asset encumbrance is the claim by the EBA that the economic literature suggest that decreasing proportions of unsecured funding imply decreasing intensity of market discipline, since unsecured investors are notably the ones that have the right incentives to carry on monitoring and to correctly price in risks. There is such a conclusion from the literature but it applies specifically to securitisation, not short-term wholesale funding.

Some relevant papers:

BIS CGFS Paper No.49, “Asset Encumbrance, Financial Reform and the Demand for Collateral Assets”, May 2013.

EBA Consultation Paper EBA/CP/2013/05, March 2013.

Hardy, Daniel C, “Bank Resolution Costs, Depositor Preference and Asset Encumbrance”, IMF Working Paper WP/13/172, July 2013.

Houben, Aerd and Jan Willem Slingenberg, “Collateral Scarcity: implications for the European financial system”, Banque de France Financial Stability Report No.17, April 2013.

Juks R, “Asset Encumbrance and its Relevance for Financial Stability”, Sveriges Bank 2013.


[1] The European Banking Authority (EBA) recently surveyed 3,638 banks in 23 EU countries in June\July 2013 and found an average asset encumbrance ratio (using their own definition) of 14.01%.

[2] Those unfamiliar with repo are sometimes misled by its accounting treatment. Assets sold as collateral in a repo remain on the balance sheet of the seller, even though legal title to those assets has been transferred. This could give the appearance that the assets would be available to other creditors in the event of default. The collateral does not leave the balance sheet of the seller because he is committed to buy back the collateral at a fixed price at the end of the repo, which means that he retains the risk and return on the collateral (if the market price of the collateral falls during the repo, the seller has to buy back at a loss, and vice versa). This accounting treatment reflects the purpose of balance sheets, which are to measure the economic substance of transactions, not the legal form. If collateral was moved off the balance sheet of the seller, it would unhelpfully disguise his leverage (this is what Lehman Brothers and MF Global did). Under International Financial Reporting Standards (IFRS), assets sold as collateral are distinguished from other assets, so the situation is transparent to investors.

[3]  In a recent discussion at the EBA, the argument was made that the use of repo needs to be reduced in order to help rebuild the unsecured market, because unsecured funding was needed by end-borrowers, who do not have collateral. The counterargument that repo was necessary to allow liquidity to flow between intermediaries (who lend to end-borrowers unsecured or against non-financial collateral) was dismissed on the grounds that repo was unnecessary, being the product purely of regulatory capital concessions, and that funding would be ensured by the Liquidity Coverage Ratio (LCR). It was not explained how the requirements of the LCR would overcome the risk-aversion of lenders or why regulators are pushing back against the collateralisation agenda of Basel III.

[4]  On a technical point, it should be noted that, for rating purposes, because of the urgency of liquidity needs, the recovery rate in money markets is always assumed to be zero. This somewhat reduces the impact of collateral on cost in the short-term funding markets.

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