Stricter banking regulations, such as Basel III, could push some banking activities into the so-called shadow banking sector, amplifying liquidity risks, says a new report from Fitch Ratings.
The rating agency says that activities involving riskier exposures, which will be subject to higher capital charges, may migrate into the “shadow banking” sector. As a result, it believes that repurchase agreements (repos), which were once viewed as a relatively mundane form of short-term financing, are likely to remain a source of liquidity risk.
It notes that during the credit crisis, repo markets were linked to both illiquidity-driven price volatility, and to funding challenges for dealers that faced diminished market access. “Given their inherent leverage, short tenor, and relative opacity, repo markets remain a potential channel for liquidity risks during market distress,” it says.
Fitch says that as markets experience turbulence, repo lenders respond rationally by deleveraging, which promotes procyclicality, exacerbating market volatility. This, among other things, means repo markets are likely to be a source of liquidity risk.
“Disruptions in repo markets could negatively affect financial institutions, which may face funding challenges given the risk aversion of [moneymarket funds] as repo lenders,” the report says. “Repo market disruptions could also impair the liquidity and valuation of assets that lose acceptance as collateral, affecting not only repo market participants, but also cash investors that take long positions without deploying leverage.”