The IMF's Statistical Systems in Context of Revision of the United Nations' A System of National Accounts
Chapter

24 Repurchase Agreements and Financial Analysis

Author(s):
Vicente Galbis
Published Date:
September 1991
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Author(s)
Makta Castello-Branco

The past decade has witnessed a significant change in financial systems, resulting in the creation of new institutions (such as money market mutual funds), new instruments (such as negotiable orders of withdrawal—NOW—accounts), and new markets (such as the futures market). Among these important financial developments is the substantial growth in the market for repurchase agreements (RPs, or “repos”), as well as in the number of participants in that market. Repos—which involve the sale of a financial asset or group of assets, with the agreement to reverse the transaction in the future-have existed for decades, but they have become considerably more popular since the beginning of the 1970s. More recently, the failures of a number of government securities dealers in the United States has raised concerns about the risks involved in repo transactions.

This paper is one of a series of studies concerned with the review of the present version of the United Nations' A System of National Accounts (SNA) and, in particular, with the appropriate treatment of financial instruments in the revised SNA. Within that context, the objective is to discuss the implications of repos for financial analysis, as well as their appropriate classification in the SNA and other statistical systems. The basic question to be discussed is whether repos should be treated as successive independent sales of existing financial instruments or as the creation of a new financial instrument, similar to a collateralized loan.

The discussion focuses on the U.S. market, where repos are widely used. However, the repo market is well established in other countries with developed financial markets.1 In all these countries, repos are used both by central banks for monetary management and by business corporations, banks, and other financial institutions for asset and liability management. This study concludes that, although the legal characterization of repos differs among the various countries, their treatment as secured loans is more appropriate for financial analysis. In general, the change-of-ownership principle gives guidance to the proper classification of a financial instrument. In the case of repos, however, it is clear that the purchaser does not effectively obtain the right of ownership, so the basic nature of transactions should be given precedence over their legal form.

The paper is organized as follows. The first section describes the market for repos in the United States and analyzes its recent expansion and the underlying risks. Section II discusses the implications of repos for monetary policy. Section III deals with the treatment of repos in financial analysis. The main conclusions are given in Section IV.

I. The Repo Market

A repurchase agreement is an acquisition of immediately available funds through the sale of securities with the simultaneous commitment by the seller or borrower to repurchase them at a later date.2 The same transaction from the perspective of the supplier of funds is called a reverse repurchase agreement (reverse repo). Whereas a repo combines a spot sale with a forward purchase, a reverse repo involves a spot purchase and forward sale.3

The Repo Contract

The repo contract establishes the underlying security or securities, the interest rate, the repurchase price, and the term and maturity of the arrangement. Normally it does not cover default arrangements involving bankruptcy of one of the parties.

In principle, any asset can be used as the underlying security in the repo transaction, but in practice U.S. government and federal agencies' securities are more widely used because of their liquidity, low risk, and active market. Other assets that can be used are money market instruments such as certificates of deposit, banker's acceptances, commercial paper, and commercial banks' loans or mortgage-backed securities. The use of a mix of different securities in a repo transaction is also common. For illustrative purposes, the following discussion will be limited to transactions involving government securities. However, the same principles apply to repos involving all classes of securities.

The role of the underlying security is only to provide collateral to the buyer or lender, not to determine the interest rate on the agreement, which is determined by the money market. The repo rate is typically lower than the rate on federal funds loans, which are not collateralized.4

The repurchase price in the repo transaction can be set either at or above the same level as the sale price. If set at the same level, the parties will arrange for a separate interest payment for the use of the acquired funds; if set above the sale price, the difference reflects the implicit interest rate on the contract. Usually a margin, or “haircut,” is set to protect the lender or buyer against fluctuations in the market value of the underlying securities.5 The amount of funds transferred (sale price) is thus equal to the market value of the underlying security plus (in the case of coupon securities) accrued interest less the margin.6 In general, the margin will be larger the longer is the maturity of the underlying security and the less liquid the security is. Haircuts range from 1 percent to 5 percent, but may be as low as 1/8 percent of a point for very short-term securities.7

Usually repos are written for a very short period of time and involve principal amounts larger than US$1 million. Standard repos include overnight (one-day maturity) and term (fixed-term multiday) repos in treasury and agency securities, but other special arrangements are also common. An “open repo” does not have any specific maturity attached to it and can be closed at the discretion of either party. Such arrangements, often called “continuing contracts,” are essentially a series of overnight repos, renewed daily, with the repo rate adjusted to reflect prevailing market conditions. The main advantage of continuing contracts is to avoid new transaction costs, since the underlying securities and the funds are exchanged only at the beginning and at the end of the contract. Consequently, the rate paid on an open repo is usually above the rate on an overnight repo. Another possibility is to engage in a “repo agreement to maturity,” in which case the repo matures at the same time as the underlying security.

In a “straight” repo transaction, the same securities are returned at the end of the contract. Those are often called “vanilla” or “plain vanilla” repos. However, it is also possible to arrange for “dollar repos,” in which different securities are returned to the borrower or seller. There are two types of dollar repos, a “fixed-coupon repo,” in which the returned securities have the same coupon rate and similar maturities as the transferred securities, and a “yield-maintenance repo,” in which the returned securities provide roughly the same return as the securities originally sold.

These special arrangements—designed to accommodate specific needs of customers—increase the flexibility of the repo agreement, and thus its attractiveness for borrowers and lenders.

Use of Repos by Participants in the Repo Market

Traditionally, repos have been used on a large scale by government securities dealers, as a form of primary borrowing, and by large commercial banks, as a secured means of obtaining short-term financing. With the development of the repo market, a variety of institutional investors started to engage in such transactions. In addition, the Board of Governors of the Federal Reserve System (FRB) has also increased its use of repurchase agreements as a means of temporarily changing the composition of its portfolio for monetary policy purposes.

As they shifted from asset management to liability management, commercial banks have extensively used federal funds and repos to finance cyclical variability in loan growth. There are several advantages in their use of the repo market. Repos are usually less expensive than other sources of short-term funds, such as federal funds. Moreover, repos are exempt from reserve requirements, which considerably reduces the effective cost of loans.8 In addition, the repo transaction offers a desirable combination of risk, maturity, flexibility, liquidity, and ease of negotiation that compares favorably with other instruments. Commercial banks and government securities dealers also engage in reverse repos to obtain government securities to be used in repo transactions.

Government securities dealers are very active in the repo market, using repo transactions, as an alternative to commercial bank loans, to finance their positions. A substantial percentage of dealers' inventories of securities is financed through the repo market. Government securities dealers also act as financial intermediaries or brokers, using the repo market to channel funds from lenders to borrowers. These arrangements are called “repo books” and involve a repo and a reverse repo. When the dealer (or the commercial bank, if acting as a middleman) matches the two “legs” of the repo—that is, obtains equal terms to maturity in the purchase and in the sale of the security—the arrangement is called a “matched book RP.” In this case the dealer's profit is insulated from movements in the interest rate, although not from default. The size of the market is limited by the amount of securities usable in such operations.

Dealers may also decide not to match the maturities of repos and reverse repos, speculating on future movements of interest rates to increase their profits. For example, if a dealer expects interest rates to rise, he arranges the repo book so that the repo has a longer term to maturity than the reverse repo.

Commercial banks and government securities dealers are usually net borrowers in the repo market. The primary lenders of repo funds are nonfinancial corporations and state and local governments; thrift institutions and pension funds also invest in the repo market.

From the lender's side of the market, repo transactions ideally supplement other cash management techniques. Any excess cash position can find a suitable short-term application that allows investors to hold only a minimal amount of funds without explicit interest return. Reverse repos are attractive to investors because they do not require commitment of funds for the full term of the repo security. Moreover, they provide a competitive yield and are considered less risky than other instruments. In addition, reverse repos can be particularly attractive to state and local governments and other public bodies that are required to invest in treasury securities. Given the existing flexibility in recording these transactions, they can record the ownership of U.S. government securities, rather than ownership of repos, and thus comply with legal requirements.

The FRB is also an important participant in the repo market. Its extensive use of repos and reverse repos as a way to adjust bank reserves began after World War II and has grown sharply in recent years as the private sector has become more adept at moving funds. In addition to its direct participation in the market, the FRB also has an important indirect role through its regulations and through its effect on interest rates in general and federal funds rates in particular.

Growth and Development of the Repo Market

Although the repo market has been operating for many years, it became quantitatively important in the early 1970s when commercial banks and their customers started to participate actively in the market. Repos were developed by government securities dealers after World War II as an inexpensive mechanism to finance their inventories. Some sources, however, trace the origin of repos to the 1920s, when the federal funds market was created. As in the case of other financial innovations, the growth in the repo market reflects several factors. Governmental regulation and regulatory changes are among the most important ones, along with the generalized increase in interest rates observed since the mid-1960s.

In a context of rising interest rates, the interest rate ceilings imposed on savings and time deposits and the prohibition of interest payments on demand deposits by the FRB's Regulation Q significantly limited the ability of commercial banks to obtain additional funds.9 Consequently, banks increasingly turned to nondeposit sources to avoid missing profitable loan opportunities. The restrictive monetary policies adopted to counteract inflation in the early 1970s and the consequent rise in interest rates reinforced this tendency. The result was an increased use of repos by commercial banks as an instrument of liability management. High interest rates also motivated investors to use cash management techniques more actively, thus contributing to the expansion of the repo market. The high rates observed in 1973–74 permanently established repos, but the market continued to grow even after interest rates fell in 1975.

The growth of repo activity by commercial banks has also been influenced by regulatory changes. For example, the 1969 amendment to the FRB's Regulation D ruled that only repos involving government and federal agencies' securities would be exempted from reserve requirements, thus discouraging trading in repos involving other types of securities.10 Beginning in 1974, the U.S. Treasury transferred most of the balances in its Tax and Loan Accounts at commercial banks to the Federal Reserve System. This reduction in treasury deposits allowed banks to use more government securities in the repo market, as the volume of government securities held as required collateral against treasury deposits was reduced.

Technological change also played an important role in the development of the repo market through its contribution to the improvement of cash management systems, thus allowing efficient collection and transfer of large volumes of funds and making participation less costly. The recent increase in government debt has also been important, since the U.S. Treasury relies heavily on the repo market to finance government deficits at the lowest possible cost.

As a result of continued expansion since the early 1970s, today the repo market is considered one of the major financial markets in the United States. There is no physical marketplace for repos. The transactions are done by telephone or over the counter directly between the two parties or through a broker. Consequently, an exact measure of total daily activity in the market cannot be obtained, but the trade volume in repos and reverse repos can reach a trillion dollars on some days. The FRB provides data on overnight and term repos as components of the money stock.11 Although these data, shown in Table 1, include only the use of repos by primary dealers, they give an indication of the growth of the repo market in the past few years.

Table 1.Development of the U.S. Market for Repurchase Agreements, 1969–87 (In billions of U.S. dollars, not seasonally adjusted)
Term Reposb
OvernightAt commercialAt thriftTotal term
YearReposabanksinstitutionsrepos
19692.22.60.02.6
19701.31.60.01.6
19712.32.70.02.7
19722.83.30.23.5
1973536.30.56.8
19745.66.81.17.9
19755.87.01.28.2
197610.612.71.314.0
197713.716.52.619.1
197818.322.14.526.6
197918.024.15.429.5
198023.427.46.634.0
198128.427.28.836.0
198233.025.98.634.5
198342.436.419.656.0
198443.932.537.369.8
198553.232.133.966.0
198659.435.448.684.0
198761.538.168.6106.7
Source: Board of Governors of the Federal Reserve System, Federal Reserve Statistical Release H.6 (Washington).

Overnight repos consist of overnight and continuing-contract repos issued by commercial banks to other than depository institutions and money market mutual funds (general purpose and broker-dealer).

Term repos are those with original maturities greater than one day, excluding continuing contracts and retail repos; includes a relatively small amount of overnight repos at thrift institutions.

Source: Board of Governors of the Federal Reserve System, Federal Reserve Statistical Release H.6 (Washington).

Overnight repos consist of overnight and continuing-contract repos issued by commercial banks to other than depository institutions and money market mutual funds (general purpose and broker-dealer).

Term repos are those with original maturities greater than one day, excluding continuing contracts and retail repos; includes a relatively small amount of overnight repos at thrift institutions.

A further sharp increase in repo activity can be observed from 1973 on, as a result of tight money and high interest rates that restricted the ability of banks to meet growing demand for credit. As an alternative source of funds, repos can therefore be viewed as vehicles for avoiding the consequences of restrictive monetary policy. The market continued growing throughout the decade, even when interest rates were falling during the 1973-75 recession. More recently, the market's growth has also reflected the increase in government debt. From Table 1 it can be seen that about half of all repo transactions are done on an overnight basis. Since term repos include maturities as short as two days, the predominance of very short-term transactions is somewhat obscured by the classification used in Table 1. Table 1 also shows that term repos, particularly those issued by thrift institutions, have increased substantially since 1982.12 This growth is associated with changes in the mortgage market in the 1980s, in particular with the development of a new instrument—the collaterized mortgage obligation (CMO). Through federally sponsored agencies like the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”), individual mortgage loans can be packaged into a federally backed, bondlike instrument that can be used in repos without reserve requirements. As a result, the amount of repos outstanding at thrift institutions increased substantially as they increasingly swapped their mortgage loans for federal agencies' securities. By enhancing the liquidity of mortgage-backed securities, the repo market makes a positive contribution to the domestic housing market. The growth in the repo market has been very impressive in recent years, not only in absolute terms but also relative to other monetary aggregates.

Risks and Regulation

Until recently, repos were considered to be very low-risk transactions because of the use of government securities and the short period of time involved in the transactions. However, after 1982, a series of failures of government securities dealers and the consequent financial losses of their customers showed that transactions involving government securities can be risky even if the underlying securities are free from default risk. These failures called attention to the largely unregulated government securities market and to the repos used to access that market.

The government securities market is characterized by free entry and intense competition. These free-market features have promoted efficiency in the market, making it attractive to a variety of investors. Until the Government Securities Act of 1986 (GSA) was enacted, the market also lacked prudential regulation, which made room for abuses and fraudulent practices by dealers that, together with the lack of investor awareness of the risks involved, resulted in a number of losses.13 The major risks associated with repo transactions are market risk and credit risk.

Market risk refers to the possibility that the market value of the underlying securities will decline. To minimize this type of risk, investors should require enough margin to protect themselves from market fluctuations, as well as monitor the securities' value (or “mark-to-market”). Failure to require enough margin or to mark-to-market was one of the factors behind the recent losses, but they were mostly associated with credit risk.

Credit risk refers to the possibility that the other party involved in the transaction will not fulfill its obligation to reverse the transaction at the end of the contract. The main cause of the recent losses was the failure of customers to gain control of the underlying securities, which allowed dealers to use them in multiple transactions. The transaction costs involved in the transfers of securities resulted in the development of repos without actual delivery of the underlying securities.14 These arrangements offered a higher return but implied a higher risk. Among these “nondelivery repos,” the most popular is the “tri-party repo,” in which an independent custodian is responsible for both the borrower and the lender. However, use of the “duebill” or “letter repo,” in which the dealer retains control over the customer's securities, has been common. Moreover, in some cases customers assumed they were dealing with one dealer—only to find later that they had been dealing with an (insolvent) affiliate.

To minimize credit risk and avoid significant losses, investors must always know the dealer. More important, they must arrange “delivery repos,” to gain control of the securities, or arrange for a custodian to keep them. From the borrower's point of view, knowledge of the dealer is also important, since he might incur a loss in case the dealer cannot meet his resale obligation.

The recent government securities dealers' failures brought to light dealers' fraudulent practices and stirred debate about the need for more regulation of the government securities industry. Some favored more regulation in the market in order to avoid additional failures and to protect investors against undercapitalized and unscrupulous dealers. Others emphasized the favorable record of the government securities market and the resulting increase in efficiency, competitiveness, and innovation that could be negatively affected by regulation. The FRB favored some form of minimal regulation, sufficient to prevent further abuses but not so much as to reduce the strength and dynamism of the market. After the 1985 failures, the Federal Reserve System started to offer an educational program to inform investors about the risks involved in repo transactions and the safeguards against these risks, to help reduce the likelihood of future losses.

Several bills were introduced in the U.S. Congress to address the issue of regulation in the government securities market. After 18 months of congressional debate, the GSA was enacted in 1986, establishing for the first time a federal system for regulation of the government securities market. The GSA required the Secretary of the Treasury to “adopt rules and regulations concerning the financial responsibility, protection of investor securities and funds, record keeping, reporting and audit of brokers and dealers in government securities.”15 The U.S. Treasury's regulations should also cover the custody of government securities held by depository institutions.

The objective of the new regulatory scheme was to enhance the protection of investors in government securities while maintaining the integrity, liquidity, and efficiency of one of the world's largest securities markets. In addition, the rules and regulations must take into account the importance of the government securities market for the implementation of monetary and fiscal policy in the United States. After consulting extensively with other federal regulators, affected parties, and trade and professional associations, the U.S. Treasury developed a set of rules and regulations, published in July 1987, that included registration, minimum capital requirements for dealers, and inspection of dealers' operations, in particular of custodian arrangements.

Recent dealers' failures have also given rise to considerable debate with respect to the legal status of repos. Some parties are legally constrained to treat repos as purchases and sales, but in general repo transactions are seen as a financing arrangement, or a secured means of borrowing and lending short-term funds, similar to a collateralized loan. During the proceedings in the case of Bevill, Bresler & Schulman, however, the Federal Reserve Bank of New York “took the unequivocal position that repo and reverse repo transactions are structured and should be given legal effect as purchases and sales.”16 The characterization of the buyer or lender as a secured or unsecured creditor is particularly important in the event that the seller or borrower goes bankrupt, since it would determine whether or not the securities could be disposed of by the lender. Nonetheless, court rulings involving bankruptcy proceedings have varied during the period 1982-85, and the question of the legal status of repos is yet to be resolved.17 The size of the repo market makes this legal battle all the more important.

II. Implications for Monetary Policy

In the United States the M1 aggregate, including currency and demand deposits, is used to provide the best link between a financial aggregate and spending. However, financial developments that created close substitutes for transferable deposits and strong incentives to move into those substitutes turned the M1 measure into an unreliable policy guide in the mid-1970s and led to the use of broader definitions of money (such as M2 and M3). More recently other developments—such as commercial banks' increased reliance, for mobilizing funds, on nondeposit liabilities such as certificates of deposit and bankers' acceptances—impaired the FRB's ability to control the monetary aggregates, forcing a revision in their definition.18 The new definitions, established in 1980, grouped together similar types of deposits with all depository institutions. Furthermore, the FRB recognized that there is no single set of monetary aggregates capable of satisfying every purpose or every user, so from that date series of the principal components of the revised monetary aggregates were published separately.

The introduction of repos in the new monetary aggregates was decided after some debate concerning their classification as liquid investments or transaction balances. Those who favored the inclusion of repos at the M1 level argued that, since their maturities are so short, repos are very similar to demand deposits.19 In support of that view, they referred to earlier econometric studies of money demand that attributed the forecast errors observed in 1974–76 to the growth in transaction-related repos. During this period, available models overpredicted the demand for real balances, prompting discussion about the factors responsible for the “missing money.”20 Some analyses suggested that the shift in money demand would have been smaller had repos been included in the definition of money. Others considered it more appropriate to classify repos as time deposits, given their characteristic as liquid investments, and thus to include them in the M2 money aggregate. They argued that, even in the event that the shortfall in the public's demand for M1 in the mid-1970s might be attributed to the increase in repo transactions, the inclusion of such transactions in the definition of money would not guarantee a stable relationship with income in the future.

Eventually it was decided that overnight repos issued by commercial banks should be included in the new M2 measure, whereas term repos should be added to the new M3. Given the potential transaction-related features of overnight repos, however, it was decided that both series would be published separately.

The hybrid nature of repos gives rise to ambiguities from the point of view of instrument classification. No ambiguity would arise, however, if repos were considered as true sales or purchases of securities. In this case, there would be a transfer of ownership between the two parties and, therefore, no real liability on either side. In contrast, if repos were viewed as the creation of a new instrument, as in the IMF's current framework for its money and banking statistics (MBS), they could be treated either as short-term deposits or as highly liquid securities. In this framework, repos would fall within a broad definition of money whenever they were repurchase liabilities of banking institutions.

The effects of repos on the money stock vary according to the participants in the repo transaction. Repos between a commercial bank and the nonbank public have the largest monetary effect. This will be illustrated in the next section, which examines the treatment of repos in monetary statistics.

III. Implications for Financial Analysis

Repos can be treated either as sales without recourse or as collateralized loans. It is current MBS practice, as stated in the IMF's draft Guide to Money and Banking Statistics (MBS Guide), to adopt the latter treatment, considering these arrangements as “creation of new financial instruments, similar to collateralized loans, and not as transfers of existing financial items.” The securities held by the buyer or lender are assumed to serve only as collateral and remain an asset of the party incurring the repurchase obligation (the borrower). This approach emphasizes the financial aspect of the repo transaction, not its legal form.

The alternative approach emphasizes precisely the legal aspect of the repo transaction as a contract to sell and later purchase securities. The focus is on the effective transfer of the underlying security and not on its use as collateral. In this case, the security is recorded as an asset of the buyer or lender until the transaction is reversed.

The treatment of repos as a secured loan seems to be in line with the view of market participants. However, countries can adopt either of these approaches in their classification of repos.21 It is therefore important to discuss the implication of different alternative treatments for the MBS, the IMF's balance of payments statistics (BOPS), and the SNA, as well as for flow-of-funds (FOF) statistics. In what follows, the difference between the two approaches will be discussed in the context of two simple examples. The first shows the balance-sheet effects of a repo between the monetary authorities (MA) and a commercial bank; the second examines a repo between a commercial bank and the nonbank public. In both cases, the monetary impact of the transaction will be examined.

Repo Between the Monetary Authorities and a Commercial Bank

The MA engage in repo transactions with banks when they want to increase the economy's overall liquidity temporarily. Thus they buy securities from a bank, which agrees to repurchase them at a later date.22 If this transaction is regarded as a financial arrangement—as in the current MBS approach—it will be considered similar to a direct loan to the bank by the MA. Accordingly, an increase in credit from the MA is booked on the liability side of the bank's balance sheet, while an increase in claims on banks is shown in the MA's assets. The counterpart to these entries will be a matching increase in the bank's level of reserves and in the MA's reserve money. The purchase of securities by the MA results in a temporary change in the bank's level of reserves and increases the bank's ability to extend domestic credit. The balance-sheet effects, for a repo transaction of $1 million, are shown below:

AssetsLiabilities
Monetary authorities
Claims on banks + $1 millionReserve money + $1 million
Commercial bank
Reserves + $1 millionCredit from MA + $1 million

The same transaction can be recorded from a legalistic point of view, which focuses on the outright purchase or sale of securities by the MA or banks. In this case, illustrated below, an increase in claims on the central government is booked on the asset side of the MA's balance sheet. A corresponding decrease in the bank's assets is recorded, characterizing the transfer of the security. Moreover, the bank's reserves are increased by $1 million, matched by an equal increase in the MA's reserve money:

AssetsLiabilities
Monetary authorities
Claims on central governmentReserve money + $1 million
+ $1 million
Commercial bank
Claims on central
government - $1 million
Reserves + $1 million

The immediate monetary impact of the repo transaction is the same under either interpretation: there is a change in reserve money, but no change in narrow or broad money. However, the financial arrangement approach is more appropriate to describe the transaction if the short-term increase in liquidity—and not the change in ownership—is the primary purpose for the transaction. Unlike the legalistic approach, it correctly indicates the increase in short-term credit from the MA to the bank. Moreover, when the balance sheet of the MA is examined to determine factors affecting change in reserve money, the adoption of the legalistic approach can lead to the erroneous interpretation that the transaction involved central bank financing to the government rather than to the banking system. The latter point could be misleading, for example, in the monitoring of public sector borrowing requirements of IMF-supported programs.

Repo Between a Commercial Bank and the Nonbank Public

The following example will illustrate the use of repos by commercial banks to obtain short-term funds in the money market. Repos are thus offered to customers as a close substitute for interest-bearing demand deposits. The balance-sheet effects of a $1 million repo transaction between a commercial bank and a corporate customer are shown below under the two alternative approaches:

AssetsLiabilities
Commercial bank
Reserves + $1 millionRepos + $1 Million
Customer
Cash − $1 million
Repos + $1 million

Under the above financial arrangement approach, the bank uses a security (or securities) from its own portfolio to obtain a $1 million short-term loan under a repo. The securities are sold to a corporate customer, which draws down from its cash reserves to make a short-term investment.23 With the funds obtained from its customer, the bank can make more loans. In this case, the repo is registered as a liability of the bank and as an asset of the corporate customer.

If the legalistic approach were adopted instead, the financial aspect of the repo transaction would not be captured. In this case, the change in the composition of the assets of both parties following the sale of the securities is emphasized. In the example below, a $1 million increase in claims on central government is booked for the customer, and a matching decrease is booked for the bank. As before, the reduction in the cash position of the customer will result in an increase in the bank's reserves and its capacity to extend credit:

AssetsLiabilities
Commercial bank
Claims on central
government − $1 million
Reserves + $1 million
Customer
Claims on central
government + $1 million
Cash − $1 million

The monetary impact of the repo transaction will be different under each interpretation. Although there is a decrease in narrow money in either case, an increase in broad money is observed if repos are considered as similar to transferable deposits, as in the financial arrangement approach. In contrast, if the legal transfer of the securities is emphasized, a decrease in domestic credit of the same magnitude is registered. The same transaction can thus result in a decrease in liquidity or a decrease in domestic credit, according to the treatment given to repos.

As in the first example, the legalistic approach is inadequate in reflecting the financial aspect of the transaction, which is the essence of a repo. In addition, the legalistic approach can complicate the classification of a common repo variation, which involves a mix of different securities. The sectorization of deposits, recommended in the MBS, would be difficult to implement in this case. Because the various securities represent liabilities of different sectors, in practice the repo could only be classified under the financial arrangement approach.

IV. Concluding Remarks

Repurchase agreements, or repos, are extensively used in countries with developed financial markets, both as an instrument of asset and liability management and as an effective tool for the execution of monetary policy. In some countries, repos have also been instrumental in the financing of government debt. The repo market is especially highly developed in the United States, where repo transactions are used on a large scale, but it is also important in other member countries of the Organization for Economic Cooperation and Development (OECD), as well as in some developing ones.

The increasing trend toward the continuous adjustment of assets and liabilities that characterized the 1960s and 1970s encouraged the growth of the repo market, which became an important market for short-term funds in the 1980s. In addition, central banks have used repos widely in monetary management. Repurchase agreements allow central banks to temporarily affect commercial banks' reserves, with little or no impact on the yield of the government securities underlying the repo transactions. The role of the repo market in the conduct of monetary policy has been particularly important in the United States, given the larger degree of tolerance with respect to reserve variations in other OECD countries. Among the OECD countries that engage in repos, only in the United States, France, Spain, and Italy are repos between banks and nonbanks considered as part of the monetary aggregates.

The legal characterization of repo and reverse repo transactions differs from country to country and is still the subject of open debate. Some argue that the economic substance, and not the form, of the transaction should determine the proper characterization of repos and reverse repos. This is the view of most market participants, who consider repos as secured loans. Others contend that such transactions should be structured as outright purchases and sales of securities. As a result of their hybrid nature, repos do not fit neatly into either characterization. However, some of the functional attributes of repos—such as the initial taking of margin, the right of substitution of the underlying securities, and the “mark-to-market” provision—strongly resemble the characteristics of secured loans, making the treatment of repos as secured loans more appropriate for financial analysis.

Within the context of the revision of the SNA, there are two issues that need further discussion. First, although repos are treated as a new financial instrument similar to a collateralized loan in the IMF's MBS, they are not explicitly dealt with in the SNA. Adoption of the MBS treatment in the revised SNA should be considered. Second, the treatment of repos as a new financial instrument in the revised SNA should be harmonized, to the extent possible, with the balance of payments treatment of repos as a direct transfer of ownership of the underlying securities.

Well-established repo markets exist in Brazil, Germany, Japan, Malaysia, Spain, and Thailand, for example.

When borrowed funds are received on the same business day, they are referred to as “immediately available funds.” These funds are usually transferred through the Board of Governors of the Federal Reserve System’s (FRB) nationwide electronic communications network, the “Fed-wire.”

In the case of the FRB and thrift institutions, however, the usual terminology is reversed, and the repo represents the point of view of the supplier of funds; the reverse repo represents the point of view of the supplier of securities.

The federal funds rate is the rate of interest paid on overnight loans of federal funds (funds on deposit in a bank’s reserve account with the Federal Reserve System).

Technically, the margin can protect either the lender or the borrower (but not both), depending on how the repo transaction is priced. Here I concentrate on the most common case, where it protects the lender.

Full accrual pricing was adopted in October 1982, in the wake of some government securities dealers’ failures (see the subsection on “Risks and Regulation,” below). When interest is ignored in the pricing, the repo transaction is said to be priced “flat.”

Stephen A. Lumpkin, “Repurchase and Reverse Repurchase Agreements,” Federal Reserve Bank of Richmond Economic Review, January-February 1987.

Repos are nonreservable borrowings only as long as the repo securities are those of the U.S. government or federal agencies (see Amendment to Federal Reserve Regulation D, 1969; Regulation D specifies which deposits of commercial banks are subject to reserve requirements).

Regulation Q (enacted in the Banking Act of 1933) set the maximum interest rates that commercial banks were allowed to pay on their deposits.

In October 1979 the FRB imposed marginal reserve requirements on net purchased funds, but these requirements were abandoned in the summer of 1980. See D. Hester, “Innovations and Monetary Control,” Brookings Papers on Economic Activity: 1 (1981).

Overnight repos are considered part of M2, whereas term repos are a component of M3 (see Section II).

The only thrift institutions with a significant amount of repo liabilities outstanding are savings and loan associations.

Between May 1982, with the Drysdale failure, and April 1985, with the Bevill, Bresler & Schulman failure, a total of $849 million in losses had been recorded.

Certified securities are physically delivered to the lender (or custodian). Book-entry, or uncertified, securities are transferred to the lender over the Fed-wire while the funds are transferred to the borrower.

Federal Register, July 24, 1987.

Federal Securities Law Reports, December 1986.

An important result was achieved in June 1984, when the U.S. Congress introduced legislation to amend the bankruptcy code, exempting repos in treasury and government agencies’ securities from the “automatic stay” provision of the code. With the amendment, lenders are allowed to liquidate the underlying securities in case of bankruptcy of the borrower, as long as the repo has a maturity of not more than one year and the securities are of certain specified types.

For more details, see Federal Reserve Bulletin, January 1979, and T. Simpson, “The Redefined Monetary Aggregates,” Federal Reserve Bulletin, February 1980.

It is even possible for the creditor to write checks on the funds, since they will be available before the checks clear; see Norman N. Browsher, “Repurchase Agreements,” Federal Reserve Bank of St. Louis Review, September 1979.

See S. Goldfeld, “The Case of the Missing Money,” Brookings Papers on Economic Activity: 3 (1976).

Some countries consider repos as a matched pair of contingent accounts, booking them within or outside the balance sheet according to local practice.

Recall from Section I that, because it involves the MA, this transaction is called a repo and not a reverse repo (as it would normally be called). The MA would engage in a reverse repo if their objective were to decrease overall liquidity.

Note that the monetary impact of the repo transaction would be different if, instead, the customer withdrew $1 million from its checking accounts in the banking system. In this case, the increase in reserves of one bank would be offset by an equal reduction of another bank’s level of reserves. Moreover, a decrease in demand deposits would lead to a decline in narrow money.

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