Download The Effect of Sunk Costs on the Outcome of

Repo Markets, Counterparty Risk,
and the 2007/2008 Liquidity Crisis1)
Christian Ewerhart
University of Zurich and NCCR Finrisk
Jens Tapking
European Central Bank
NASM, June 20, 2008
1) The opinions and views expressed in this presentation are those of the presenter alone,
“Repo
Markets,
Counterparty
Risk,
the 2007/2008
Liquidity
Crisis”
and
not
necessarily
those of
theand
European
Central
Bank.
NASM, June 20, 2008, Christian Ewerhart, University of Zurich
1
Observation 1: There is a disparity in collateral usage
Average collateral usage during 2006 in primary and secondary funding
“Repo Markets, Counterparty Risk, and the 2007/2008 Liquidity Crisis”
NASM, June 20, 2008, Christian Ewerhart, University of Zurich
2
Observation 2: Recent market developments have
apparently reinforced the disparity
Development of collateral usage in commercial bank refinancing
Primary market:
Secondary market: Since August 2007, structured instruments have
been used less as collateral in market transactions (Clearstream, 2007,
Comotto, 2008)
“Repo Markets, Counterparty Risk, and the 2007/2008 Liquidity Crisis”
NASM, June 20, 2008, Christian Ewerhart, University of Zurich
3
Plan
Introduction
The basic model
Feasibility of the market transaction
Welfare implications
Conclusion
“Repo Markets, Counterparty Risk, and the 2007/2008 Liquidity Crisis”
NASM, June 20, 2008, Christian Ewerhart, University of Zurich
4
Set-up
1 + m assets:
•
cash, asset j = 0 (riskless, no interest)
•
m ≥ 1 collateral assets j = 1,…, m (risky and/or illiquid)
Two counterparties i = 1, 2 (thought of as commercial banks)
•
initial endowment (date 0) of cash qi0 ≥ 0 and collateral
assets qij ≥ 0, j = 1, …, m
•
utility function ui ( . ) weakly concave, strictly increasing,
differentiable
•
maximize expected utility from terminal payoffs (date 2)
•
must hold cash level ≥ qi0 between dates 1 and 2 (i.e., both
counterparties satisfy the constraint in the absence of further
transactions)
“Repo Markets, Counterparty Risk, and the 2007/2008 Liquidity Crisis”
NASM, June 20, 2008, Christian Ewerhart, University of Zurich
5
Liquidity shock determines roles in the money market
Between dates 0 and 1, there is a customer request
•
publicly observable transfer of random amount λ > 0 of cash
at date 1 (normalized to one in the basic model)
•
with equal probability, the transfer will be from Bank 1 to
Bank 2 ( iL = 2 , iB = 1 ) or vice versa ( iL = 1 , iB = 2 )
Resulting roles in the money market:
•
“Lender (L)” = Bank iL
•
“Borrower (B)” = Bank iB
“Repo Markets, Counterparty Risk, and the 2007/2008 Liquidity Crisis”
NASM, June 20, 2008, Christian Ewerhart, University of Zurich
6
Three relevant states of nature
Value date
(Date 1)
Termination date
(Date 2)
πG
πB
πL
Neither lender nor
borrower defaults
(the “good” state)
State G
Only the borrower
defaults
State B
Only the lender
defaults
State L
“Repo Markets, Counterparty Risk, and the 2007/2008 Liquidity Crisis”
NASM, June 20, 2008, Christian Ewerhart, University of Zurich
7
Time structure – basic model
Date 0
Date 1
Initial
Customer
endowments request
• cash
• collateral
assets
Repurchase
agreement:
• collateral
• haircut
• repo rate
Outside
options
Cash transfer
from the lender
to the borrower
Deposit of
borrower‘s
collateral with
lender
Reserve
requirements
fulfilled
“Repo Markets, Counterparty Risk, and the 2007/2008 Liquidity Crisis”
NASM, June 20, 2008, Christian Ewerhart, University of Zurich
Date 2
Uncertainty resolved:
• state of the world
• liquidation values and
repurchase prices
In state G:
• repayment of principal
and interest
• transfer of collateral
assets
In states B and L:
• default of one
counterparty
• monetarization of
collateral claim
• netting
8
Netting in the spirit of the TBMA/ISMA GMRA
Informal description of Assumptions 2-4
State B
When the borrower defaults, then
• the lender may sell the collateral and use the
proceeds to satisfy his claim on principal and
interest
• any shortfall will be lost
Lender‘s
risk
• any surplus must be forwarded to the
borrower‘s insolvency agent
State L
When the lender defaults, then
• the borrower may purchase assets equivalent
to the transferred collateral
• any costs exceeding principal and outstanding
interest will be lost
• any savings must be forwarded to the lender‘s
insolvency agent
“Repo Markets, Counterparty Risk, and the 2007/2008 Liquidity Crisis”
NASM, June 20, 2008, Christian Ewerhart, University of Zurich
Borrower‘s
risk
9
Assumption 2: Netting
~
Let vb denote the liquidation value of the collateral portfolio at the
termination date, conditional on the borrower‘s default.
~
Similarly, let va denote the replacement cost of the collateral portfolio
at the termination date, conditional on the lender‘s default.
“Repo Markets, Counterparty Risk, and the 2007/2008 Liquidity Crisis”
NASM, June 20, 2008, Christian Ewerhart, University of Zurich
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Assumption 3: Subordination
“Repo Markets, Counterparty Risk, and the 2007/2008 Liquidity Crisis”
NASM, June 20, 2008, Christian Ewerhart, University of Zurich
11
Assumption 4: No windfall profits
“Repo Markets, Counterparty Risk, and the 2007/2008 Liquidity Crisis”
NASM, June 20, 2008, Christian Ewerhart, University of Zurich
12
Expected utilities at the time of contracting
Lender:
Borrower:
“Repo Markets, Counterparty Risk, and the 2007/2008 Liquidity Crisis”
NASM, June 20, 2008, Christian Ewerhart, University of Zurich
13
Assets with lower index are more liquid and/or less risky
“Repo Markets, Counterparty Risk, and the 2007/2008 Liquidity Crisis”
NASM, June 20, 2008, Christian Ewerhart, University of Zurich
14
First result: It is optimal to expose
both counterparties to non-trivial credit risk
Theorem 1. Under Assumptions 1 through 5, any Pareto efficient
standard repurchase agreement will expose both lender and
borrower to non-trivial credit risk.
Rationale:
• If one party is fully protected, the other party is fully exposed
• The relative willingness to pay between haircut and repo
rate can therefore not be identical for lender and borrower
• This contradicts Pareto efficiency!
Note: This result holds generally unless liquidation values or
replacement costs have mass points at strictly positive
valuations.
“Repo Markets, Counterparty Risk, and the 2007/2008 Liquidity Crisis”
NASM, June 20, 2008, Christian Ewerhart, University of Zurich
15
Consequence for the interbank market:
good collateral drives bad collateral out of circulation
Recall that qjiB denotes the borrower‘s holdings of collateral j
“Repo Markets, Counterparty Risk, and the 2007/2008 Liquidity Crisis”
NASM, June 20, 2008, Christian Ewerhart, University of Zurich
16
Plan
Introduction
The basic model
Feasibility of the market transaction
Welfare implications
Conclusion
“Repo Markets, Counterparty Risk, and the 2007/2008 Liquidity Crisis”
NASM, June 20, 2008, Christian Ewerhart, University of Zurich
17
Illustration: Minimum acceptance rates for the lender
and maximum acceptance rates for the borrower
Example for a fixed collateral composition
“Repo Markets, Counterparty Risk, and the 2007/2008 Liquidity Crisis”
NASM, June 20, 2008, Christian Ewerhart, University of Zurich
18
Theorem 3: Market break-down
Consequences:
• Two-tiered market structure also in secured market
(extending results by Freixas and Holthausen, 2004)
• Role for CCPs
• Limitations to capacity of specialized banks to hedge
liquidity risks (applying Kashyap, Rajan, and Stein, 2002)
“Repo Markets, Counterparty Risk, and the 2007/2008 Liquidity Crisis”
NASM, June 20, 2008, Christian Ewerhart, University of Zurich
19
Plan
Introduction
The basic model
Feasibility of the market transaction
Welfare implications
Conclusion
“Repo Markets, Counterparty Risk, and the 2007/2008 Liquidity Crisis”
NASM, June 20, 2008, Christian Ewerhart, University of Zurich
20
Overview: The model with central bank
“Repo Markets, Counterparty Risk, and the 2007/2008 Liquidity Crisis”
NASM, June 20, 2008, Christian Ewerhart, University of Zurich
21
To determine the equilibrium composition of central bank
collateral, we need to assume that the private repo market works
Otherwise, the composition of collateral with the central bank would
be (partly) indeterminate.
“Repo Markets, Counterparty Risk, and the 2007/2008 Liquidity Crisis”
NASM, June 20, 2008, Christian Ewerhart, University of Zurich
22
Vis-à-vis the central bank, bad collateral drives
good collateral out of circulation
Def.: The compositions of collateral with the central bank are stable
when there is, for any λ>0, either a market break-down or a Pareto
efficient SRA involving no substitution.
“Repo Markets, Counterparty Risk, and the 2007/2008 Liquidity Crisis”
NASM, June 20, 2008, Christian Ewerhart, University of Zurich
23
The extension of the set of eligible
collateral may increase welfare
“Tight” eligibility
~
E[ uL ]
“Loose” eligibility
Note: Liquidity policy
may have to adjust to
ensure implicit
opportunity rates
uL
~
E[ uB ]
uB
Federal Reserve?
“Repo Markets, Counterparty Risk, and the 2007/2008 Liquidity Crisis”
NASM, June 20, 2008, Christian Ewerhart, University of Zurich
24
However, in general the lender may be worse off
“Tight” eligibility
~
E[ uL ]
“Loose” eligibility
This case may occur when
under the tight collateral
regime, the central bank is
also tight with liquidity
uL
uB
“Repo Markets, Counterparty Risk, and the 2007/2008 Liquidity Crisis”
NASM, June 20, 2008, Christian Ewerhart, University of Zurich
~
E[ uB ]
25
The welfare gain may also be zero
“Tight” eligibility
~
E[ uL ]
“Loose” eligibility
This case may happen
when collateral used vis-àvis the central bank
cannot be used in the
market (due, e.g., to
concerns about illiquidity
and counterparty risk)
uL
uB
ECB?
“Repo Markets, Counterparty Risk, and the 2007/2008 Liquidity Crisis”
NASM, June 20, 2008, Christian Ewerhart, University of Zurich
~
E[ uB ]
26
Plan
Introduction
The basic model
Feasibility of the market transaction
Welfare implications
Conclusion
“Repo Markets, Counterparty Risk, and the 2007/2008 Liquidity Crisis”
NASM, June 20, 2008, Christian Ewerhart, University of Zurich
27
Conclusion (1)
We have found evidence that there is an increasing discrepancy
between uses of collateral in primary and secondary funding markets
To explain our observations, we have considered a bargaining model
with two-sided credit risk, and derived the following results:
• in a repo, it is typically optimal to expose both counterparties to
non-trivial credit risk
• if there is a choice of collateral in a market transaction, then the
most liquid and least risky assets will be used up first
• however, if the best collateral available is still relatively illiquid or
risky, and if there is non-negligible bilateral counterparty risk, then
no market transaction may be feasible
“Repo Markets, Counterparty Risk, and the 2007/2008 Liquidity Crisis”
NASM, June 20, 2008, Christian Ewerhart, University of Zurich
28
Conclusion (2)
We have extended the model to reflect the dominant role of the
central bank in the repo market.
It was shown that essentially unaffected by the haircut requirement,
the least liquid and most risky assets will be deposited with the
central bank
A less restrictive collateral policy applied by a central bank may
indeed lead to a welfare improvement for market participants, with
two notable exceptions:
• the welfare gain is uncertain if the lender has a strong
bargaining power under the tight regime
• the welfare gain may be nil if the quality rather than the
quantity of collateral is the problem
“Repo Markets, Counterparty Risk, and the 2007/2008 Liquidity Crisis”
NASM, June 20, 2008, Christian Ewerhart, University of Zurich
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