Now that post-crisis regulations surrounding capital requirements for risk-weighted assets have mostly been hammered out, rule-making is turning to leverage and liquidity. While it’s still early in the process, a declining repo market could be a sign of tighter short-term lending markets once new regulations are in full effect.

“As banks increase funding durations, shrink low-return assets and re-price certain business to account for less leverage, we expect the ultimate impact to be a smaller, more expensive short-term financing market which may impact overall trading activity,” writes Goldman Sachs analyst Richard Ramsden. “The net impact to bank earnings is harder to determine as pricing improves but the overall size of the market/activity levels may be reduced.”

SLR is already the binding capital constraint for many banks

Ramsden argues that the supplementary leverage ratio is now the binding capital constraint for many large US banks. Repo and securities lending, which have low margins and are becoming capital intensive are becoming less attractive for banks that are rethinking how to make the best use of their balance sheets.

slr pressures repo 0514 Leverage

Under the old rules, quarterly SLR was calculated as the average SLR on the last day of each month, causing repo rates to jump on the last day of each month as banks tried to keep their SLR as low as possible. This somewhat artificial metric has recently been changed to use daily averages, which should make repo rates more stable, but it also probably means that repo rates will be permanently higher.

repo rate month end spike 0514 leverage

Shadow banking could come in to fill the void in short-term lending, but Ramsden doesn’t see this as very likely. Short-term financing requires major economies of scale in order to net out risks effectively and to make the necessary overhead (credit analysis on counterparties, operations) worthwhile. It’s not impossible for alternatives to ramp up operations and become big enough to make a profit, but then they would draw the attention of regulators. It’s hard to imagine a big hedge fund taking the risk of being named a systemically important financial institution with all the additional regulatory requirement that come with it.

Lower repo volumes will hurt banks’ EPS… probably

“While the changes to the short-term financing markets will certainly impact banks, given the numerous variables that are in play (size of the repo market, bid/ask spreads, trading volumes), it is hard to determine what the net impact to earnings will be,” writes Ramsden.

Repo volumes track bond trading volumes pretty closely (which seems reasonable since bonds are usually used as collateral in the repo market). Both bond and repo volumes are trending down, and if new leverage and liquidity rules causes repo markets to fall hard bond markets might not be far behind.

repo v bond volumes 0514 leverage

But short-term lending will also have wider spreads, as evidenced by the month-end spikes in repo rates that we have already seen. Ramsden also argues that US banks could benefit from increased market share as some European banks back out of the market, though he says the most likely scenario is for US banks to take a hit.