One of the lessons of the financial crisis was that repo markets, OTC derivatives, and other asset markets caused financial institutions to be far more interconnected, and the whole system more fragile, than regulators had imagined. To get a better handle on how these effects, the Federal Reserve required bank holding companies (BHC) with more than $10 billion to start reporting their collateral arrangements in much greater detail, and now that the data has started there appears to be strong correlation between liquidity and concentration in collateral used.
“Although BHCs have large exposure to banks, most of the collateral involved maintains minimal credit risk and is highly liquid. Conversely, contracts with corporations tend to use more diverse types of collateral, but the volume of these contracts is only one-quarter that of contracts with other banks,” write Marius Rodriguez and Hamed Faquiryan of the Economic Research Department of the San Francisco Fed. “Moreover, the exposure to hedge fund counterparties is minimal and is collateralized by safe, liquid instruments.”
Most BHC collateral is cold hard cash
The vast majority of BHC collateral arrangement are made with other banks and rely on cash, either USD or foreign hard currency (71% and 80.5% respectively). US Treasuries and agency debt (Fannie Mae, Freddie Mac, and Ginnie Mae) make up another 6.5% of collateral, meaning that about 13% of collateral is even remotely risky. Corporations and hedge funds are the second and third largest responsible counterparties, as you might have guessed, while sovereigns and monolines play a minor role.
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BHC require collateral to be either liquid or diversified
The most encouraging part of the report is that bank’s clearly require collateral to either be liquid or diversified; they aren’t going to risk getting stuck with claims on a large pool of illiquid assets and have to watch its value drop. Corporations tend to use a broader base of less liquid assets, while banks and hedge funds tend to use liquid assets (cash, Treasuries) with much higher concentration. (Note the HHI scale here appears to be normalized to 100; it’s sometimes normalized to 10,000.)
After years of stress tests and tightened regulation, you would expect to get these kinds of sensible results, but what’s probably more important is that the Fed’s new collateral reporting requirements seem to give enough detail to capture bank’s exposure so that if these relationships start to get out of whack we may be able to do something in advance.