Wednesday, October 09, 2013

Basil 3 And Repo Market

Most people don't recognize the direct effect that Bank of International Settlement Basil 1 Accords had on Japan increasing reserve requirements, contacting the money supply and triggering their "Lost Decade".  Similarly, these same people don't recognize how implementation of Basil 2 in 2007 by the FED triggered the collapse of the housing market in 2008. 

Now in 2013 we are seeing the the slow implementation of the Basil 3 Accords which, in an attempt to "stress-test" banks, is increasing reserve requirements, thereby contracting the money supply again.  One of the direct effects of Basil 3 is to do away with the repurchasing or "Repo" market. 

When mega-banks borrow money from the FED, they turn around and make loans on that money.  According to fractional reserve banking principles and the money multiplier, when a mega-bank borrows $1000, they can turn around and lend $9000, keeping the original $1000 as cash reserves "on-hand". 

However, banks don't like to hold actual "dollars (USD)" because of inflation.  As inflation rises, the value of the reserves diminishes. So, these banks convert the USD into US Bonds, and even Credit Default Swap Derivatives (Bond Insurance).   

When the banks need actual USD cash again, the banks use a Repo market and trade their US Bonds and Derivatives for a short-term loan. The loan may be as short as overnight. The bank is then able to have actual dollars (USD) to meet its needs for that period and will "repurchase" the US Bonds back the next day.

Well, financial news is reporting that with the implementation of the Bank of International settlement Basil 3 Accords, banks will be required to hold onto more reserves.  In addition, the Accords may do away with the short-term Repo market that has allowed banks to hold  reserves in the form of Bonds and Derivatives.

The net effect of all these changes is that the Basil 3 Accord policy yet again serves to contract the money supply.  If the FED at the same time ends or tapers its Quantitative Easing (QE), we could see the economy fall off another fiscal cliff.

What happened in 2008 with Bear Sterns is that there was a rumor (conspiracy) that Bear Stearns had liquidity problems.  There was then a run on the bank. 18 billion in reserves was reduced to 2 billion overnight.  Bear Sterns didn't have enough reserve cash on-hand to satisfy the withdrawals.  Usually the banks lend each other cash via the Repo market or LIBOR market to meet each others short-term cash needs. No one would lend to Bear Sterns and they became immediately insolvent.

Instead of the FED (lender of last resort) lending Bear Sterns money to meet its short-term cash needs, the FED allowed Bear Sterns to declare bankruptcy and then loaned JPMorgan the money to buy up Bear Sterns at pennies-on-the-dollar. The FED bailed out AIG, but they let Bear Sterns get bought out.

[a repo is a secured loan since the lender gets a collateral for the cash being lent out -- the only difference is that the ownership of the collateral is transferred in the case of repos, whereas under a loan the borrower retains ownership of the collateral. The difference between the selling price and the repurchase price is the effective interest in these transaction.

Rates on repo are different from LIBOR rates, since repos are considered a secured loan whereas the LIBOR is used for unsecured interbank lending.

The US repo market is estimated to be around $4.5 trillion in 2008.]

Traditionally, banks are to lend out 100% of deposits.  However, in the era of QE.  Banks can make more money by investing in the stock market, and buying oil rigs, airports and even speculating in the derivatives market.  How banks get around Glass-Steagall which limited banking practices to banking is via the Repo market. The mega-Banks take the QE money, buy US Bonds, then put those bonds up as collateral on the Repo market and get "laundered money" in exchange to then speculate with in the markets instead of using the reserves to issue small-business loans.

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