Last year, the Bank of England took a leaf out of the FRBNY’s book and launched a blog site for its analysts. The site is called Bank Underground. Notwithstanding this attempt to sound a big edgy and an unfortunate tendency towards silly titles (eg “Izzy Whissy let’s get Vizzy”), there’s good stuff here. But there is also the occasional suspect offering.
One of these is a blog that attracted considerable interest from financial journalists at the end of last year: “What do we know about non-bank interconnectedness” by Zijun Liu and Jamie Coen (25 August 2015). The focus of press interest was the authors’ statement, “there is evidence that some non-bank financial institutions have entered the core of the repo network”.
This proposition chimed with the widespread but so far unsubstantiated expectation that, as new regulation hobbles the ability of banks to act as intermediaries, non-bank financial institutions (NBFI) will take their place. And intermediation by NBFIs would of course be a manifestation of expanding “shadow banking”, the search for which excites financial journalists in much the same way as the search for dark matter affects astrophysicists. The blog on interconnectedness proclaimed that the Bank of England had found evidence of such activity. Cue phone calls from excited journalists.
The blog discussed the results of an analysis of the top 60 exposures of 20 major UK banks and investment firms to other banks, other financials and non-financials through transactions in repo and derivatives. It graphically illustrated that, while NBFIs accounted for only 9 of the 30 institutions at the core of the derivative network, they accounted for 14 out of 34 at the core of the repo network. The authors added that the NBFIs in the repo core were the largest counterparties in the network (and four of the largest five NBFIs were hedge funds). The conclusion was that there is “a risk that hedge funds effectively become part of the interdealer repo market’ and a warning that ‘if that happens, stresses at one hedge fund may spread to the entire repo market”.
One can appreciate why the journalists were getting excited. The problem is that the authors of the blog do not appear to be entirely clear about the difference between the various types of securities financing transaction (SFT). In particular, they made an assumption that repos are the same as margin lending. This critical piece of information is hidden away in parenthesis on page 5 of the blog, where it says “repo includes margin loans”. No it doesn’t! Pledge-based margin lending is a very different beast to sale-based repo and is much more important to hedge funds. Among many other things, margin lending is intermediated by prime brokers, of whom hedge funds try to use more than one (the larger the hedge fund, the more prime brokers). Perhaps a better, albeit less dramatic conclusion, would have been that hedge fund business is well diversified across dealers. And this would be consistent with the observation that “banks’ direct credit exposures to non-banks are currently small”.
Another fundamental objection to the suggestion that hedge funds have penetrated the core of the repo market is that such a conclusion cannot be logically inferred from the data. The statistical “core of the network” does not necessarily coincide with the interdealer market. This is especially true when one is using data that measures net volume. In the European repo market, some 70% of transactions go through CCPs. In addition, much non-CCP business is netted bilaterally and netting impacts interdealer activity far more intensely than dealer-customer business, so net volumes will tend to overstate dealer-customer business.
Interestingly, despite their bold conclusions, the authors bemoan their inability to identify transactions between non-banks due to lack of “hard evidence” and laud the imminence of the transaction-level repo reporting requirements that are due to be introduced in Europe. Was the wish for data on NBFIs father to the thought that there is evidence of disintermediation by shadow banks?
Of course, the enthusiasm of regulators for wider and deeper reporting is in stark contrast to the misgivings of many in the industry. There are considerable doubts as to the value of the reporting requirements, particularly given the poor drafting of some of the relevant regulations and in view of the debacle following the rushed imposition of reporting requirement on derivatives activity. Questions are also being asked as to how regulators will cope with the deluge of data and how will they sensibly interpret the numbers without a working knowledge of the market? The Bank of England’s blog will be taken as evidence in support of that last objection.
A final point of interest in the blog is the alarm that appears to be occasioned by the discovery that NBFIs borrow from banks and that banks are lending to these NBFIs against collateral. To say that “other NBFIs seem to be leveraging up via the repo market” hints at disapproval. Too much borrowing would clearly be a problem but, as noted already, the authors comment that banks’ direct credit exposure to non-banks is in fact quite small. And if banks are going to lend, surely secured lending is commendably prudent?
 I should perhaps declare a conflict of interest here. It does not appear that academics will have access to the detailed datasets.