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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 10 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 29