Wednesday, March 17, 2010

What's a repo?

Marketplace has a nice video on how Repo 105. Unfortunately, they completely miss the role repos play in the banking system. It actually took me a while to figure this out and I understand the banking system very well, so this may be confusing other people as well.

All banks with reserve accounts at the Fed have reserve requirements. These reserve accounts are primarily used for payment settlement, but are also used in a convoluted way to set the Federal Funds Rate. At the close of business, some banks find themselves short their reserve requirements, and other banks find themselves long their reserve requirements, and so those that are short borrow from those that are long via repos. This overnight, interbank lending market uses repos as the vehicle for its overnight interbank loans.

Note that the repo market is not some shady thing, it is how the Fed has decided to enable payment settlement and set the FFR. If all banks closed long reserves, the Fed would intervene in the market until some were short, and force those banks to repo with other banks.

This mechanism means that quality of collateral and counterparty risk enter into a market for payment settlements and the FFR, which is a terrible design. Instead, the Fed's discount window should be the mechanism for payment settlements, and it could set the FFR to zero and be done with it.

James Hamilton is sympathetic to why the Fed should have regulatory authority, despite it's failure to do so.
Insofar as the Fed is expected to fulfill its function as a lender of last resort through the discount window, surely it needs detailed knowledge of the borrower's financial situation. And actionable information on the financial system's health and stability is just as surely essential for knowing when and how fast to change interest rates.
If you understand how the banking system works, however, you would have the Fed lend uncollateralized (thus solving the issue of liquidity risk) and rely on the FDIC to assess capitalization, and hence, solvency. The Fed should not be judging solvency because it is the ultimate liquidity provider to the payment settlement system.

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