NY Fed to increase repo oversight after reform delays

NEW YORK Wed Feb 15, 2012 5:39pm EST

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NEW YORK (Reuters) - The New York Federal Reserve on Wednesday said it may consider restrictions on the $1.67 trillion tri-party repurchase agreement market, dissatisfied with an industry committee's progress on reducing the loans' risks for the financial system.

The tri-party agreements, or repos, are a prime source of short-term bank funding and are backed by Treasuries or riskier collateral, including mortgage-backed debt. Federal Reserve Chairman Ben Bernanke and others blamed repos as one of the leading factors behind the 2008 financial crisis.

The New York Fed said it may restrict the type of collateral that can be used to back these loans after the committee it set up to deal with weaknesses in the market reported on Wednesday that cutting sizable risks would take several more years.

"The tri-party repo market's infrastructure exhibits significant structural weaknesses that undermine market stability in a stressed environment," the New York Fed said in a statement on its website. "These structural weaknesses are unacceptable and must be eliminated."

The New York Fed further said additional options to increase oversight may include setting up an industry-financed facility that would be used to help an orderly liquidation of repo collateral in the event a borrower fails.

Reforming the tri-party market is seen as among the most vital measures needed to reduce systemic risks in financial markets still living in the shadow of the 2008 crisis.

CREDIT RISK

In tri-party trades, JPMorgan Chase & Co or Bank of New York Mellon Corp act as intermediaries for lenders and borrowers and arrange for the settlement of the loans and the collateral behind them.

These firms extend intraday credit to loan counterparties, which helps smooth the process. But that also means that the two clearing banks remain heavily exposed to the risk of a failure by a large counterparty and that the other participants in the market remain heavily exposed to the financial health of JPMorgan and BNY as intermediaries.

The industry task force, chaired by Darryll Hendricks of UBS, said it has been unable to effectively eliminate this risk. Now, reform "requires firm-specific actions, rather than the idea generation and vetting that the task force provided."

The task force includes the two clearing banks as well as all large dealers, Fannie Mae, large fund managers and industry groups.

Their objective is that the credit extended by the clearing banks be capped at 10 percent of size of the dealer's notional tri-party book.

JPMorgan, BNY and the Depository Trust & Clearing Corp, which runs a platform for banks to trade and settle repo trades with each other, set timelines spanning several years to meet this goal.

MORE OVERSIGHT

The Fed, however, expressed disappointment with the industry's committee's progress, noting that the task force "has not proved to be an effective mechanism for managing individual firms' implementation of process changes."

Restrictions on collateral that can be used to back trades could reduce the size of the market, or make the cost of the loans more expensive.

Any ultimate reforms could reduce availability of short-term credit or make it more expensive for banks to finance asset purchases, though no changes are expected for some time.

The New York Fed added that dealers need to take further steps to reduce their reliance on short-term financing and that investors need to ensure that they run robust risk management processes regarding the credit and liquidity risks of the market.

(Reporting by Karen Brettell; Editing by Padraic Cassidy)

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