Background:
The banking system is facing unprecedented challenges in the wake of the Covid-19 pandemic, low interest rates, increased regulation, and the very recent events relating to Silicon Valley Bank and Credit Suisse. With rising interest rates some banks are finding it more difficult to maintain profitability and solvency, while also meeting the needs of their customers and shareholders. As we have seen, some banks have failed or been acquired by stronger competitors, resulting in potential losses for depositors and creditors.
One of the main causes of bank failures is insolvency, which means that a bank’s assets are worth less than its liabilities. This can happen when a bank makes bad investments or loans that turn sour, or when it faces a sudden run on deposits by customers who lose confidence in its ability to repay them. Another cause of bank failures is illiquidity, which means that a bank does not have enough cash or liquid assets to meet its obligations. This can happen when a bank faces an unexpected surge in withdrawals or payments, or when it cannot access funding from other sources.
When a bank fails, it can have serious consequences for the financial system and the economy. Depositors may lose some or all of their money if their deposits are not insured by a government agency or scheme. Creditors may face losses or delays in recovering their claims on the bank’s assets. Other banks may face contagion effects if they are exposed to the failed bank directly or indirectly through interbank lending or derivatives contracts. The failure of one bank can also trigger a loss of confidence in other banks, leading to more runs on deposits and funding difficulties.
Solution:
One way to mitigate these risks is to use the repurchase agreement (repo) market as an alternative source of funding and investment for banks and other financial institutions. The repo market is where firms trade debt securities (such as government bonds) for cash on a short-term basis, usually from 1 day to 365 days. The seller agrees to repurchase the securities at a higher price by a certain date, effectively borrowing cash from the buyer at an interest rate known as the repo rate. This repo rate can be higher than the corresponding bank interest rate for unsecured cash deposits.
The repo market has several benefits for both cash depositors (such as firms or individuals who hold cash with banks) and borrowers of cash (such as the banks).
For cash depositors, it offers an option to deposit cash on a secured basis, meaning that they have collateral (securities) in case the borrower defaults. It also allows them to earn higher returns than depositing unsecured cash at banks or holding low-yielding Treasury bills.
For cash borrowers, it provides access to low-cost secured financing to purchase securities, support market-making activities, and finance trading strategies. It also contributes to price discovery and efficient allocation of capital in the financial system.
A limitation is that the repo market is mainly accessible to the largest specialist institutions. Most institutions face difficulties in entering or participating in this market.
There are new and innovative solutions coming to market that bridge the gap between the wholesale repo market and depositors holding large cash balances. Cash holders are able to deposit their cash with their chosen bank on a secured basis for any period up to 12 months at attractive interest rates. In return, the bank provides collateral for the same period and same value which is agreed in advance with the cash depositor (e.g. government bonds or other securities).