U.S. clearing banks submit repo reform proposals to Fed

By Elinor Comlay and Kristina Cooke

NEW YORK, July 10 (Reuters) - The two U.S. clearing banks for tri-party repurchase agreements, Bank of New York Mellon Corp (BK.N) and JPMorgan Chase & Co (JPM.N), have submitted proposals to the Federal Reserve on how to make the market more resilient.

The banks told Reuters that the proposals for fortifying the more than $2 trillion market include establishing an emergency entity to support dealers in crisis and expanding financing through existing central counterparties.

The credit crisis has added urgency to ongoing talks on how to better protect the largely behind-the-scenes market against a loss of confidence in the two clearing banks. The banks play a critical market role, standing between borrowers and lenders and guarding the collateral pledged under loans.

Repos, or repurchase agreements, are contracts for the sale and future repurchase of a financial asset, most often U.S. Treasury securities. Although legally a sequential pair of sales, in effect a repo is a short-term interest-bearing loan against collateral. Repos are widely used for investing surplus funds short term, or for borrowing short term against collateral.

In March, Fed Chairman Ben Bernanke called for reforms to the tri-party repo market -- a vital part of the financial system's plumbing -- saying a central clearing system was worth considering.

But the costs of creating and running such a stand-alone entity could outweigh the benefits, and Bank of New York and JPMorgan are not alone in suggesting proposals that would strengthen, but maintain, the existing system.

"If you expect this entity to support the market in times of various types of repo failures, you have to give it the capital with which to do so," said Joseph Mason, a professor of banking at Louisiana State University. A diversified commercial or investment banking entity has access to capital that an independent, monoline entity would not, he explained.

The Federal Reserve Bank of New York declined to comment on the proposals.

After the failure of investment bank Bear Stearns, the Fed put in place an emergency lending facility for primary dealers, which was expanded in the aftermath of Lehman Brothers' collapse.

The facility helped stabilize the repo market but it is only a temporary fix as it is authorized under a provision of the the Federal Reserve Act that allows such lending only when conditions are deemed "unusual and exigent."

Bernanke said in March that permanent reforms are needed "given the magnitude of exposures generated and the vital importance of the market to both dealers and investors."

TWEAKS

Bank of New York Mellon is proposing a number of tweaks to the existing system, including expanding loan margins to cover liquidity risk as determined by portfolio stress tests. It has also suggested expanding general collateral financing through the existing Fixed Income Clearing Corporation (FICC) or another central counterparty, according to a spokesman for the bank.

JPMorgan is advocating developing an industry plan for how to handle the default of a major lender or dealer in an orderly fashion and the bank believes this may mean establishing a centralized liquidation agent in such situations.

"At the time of a default, centralized liquidation would help to mitigate negative market impact," said Kelly Mathieson, global head of clearing and collateral management at JPMorgan in New York. "Planning now for that possibility makes good sense," she added.