By Douwe Miedema and Lauren Tara LaCapra
WASHINGTON/NEW YORK (Reuters) - Wall Street banks are arguing that a proposal from U.S. regulators intended to rein in risk taking could severely hurt the $7 trillion repurchase market, a critical source of short-term loans in the financial system.
A new rule, known as the supplemental leverage ratio, is being proposed by the Federal Reserve, but also globally, as regulators seek to control a market they see as unstable enough to cause a new financial crisis.
But the banks are arguing that the rule, and a host of related proposals expected from regulators in coming months, could drain appetite for the U.S. Treasuries market and raise costs of funding for many institutions, senior Wall Street executives said in interviews.
Rather than reducing dangers in the system the rule could increase them by providing banks with an incentive to hold higher-risk securities, the executives claim.
"It's crazy: a government bond looks as risky as a triple-C bond," one senior Wall Street executive said, referring to how the banks would have to treat all assets on their balance sheets alike. In other words, a super-safe U.S. Treasury would be valued on par with a far-riskier and lower-rated "junk bond."
One other executive at a Wall Street bank said that Treasury bonds are "innocent bystanders, getting killed" by the regulators' action.
But U.S. regulators are not in a mood to change course, meaning that a collision with Wall Street is likely. In interviews, several regulators said they are determined to reform the repo market.
One senior regulatory source said U.S. bank supervisors are wary that the repo market is unstable when put under pressure. A run on Lehman Brothers in the repo market in 2008 was one of the main reasons why the investment bank collapsed.
The stakes are big for the industry as well as the U.S. government and regulators. Citigroup Inc, JPMorgan Chase & Co, Goldman Sachs Group Inc and Morgan Stanley hold $1.2 trillion in assets and $804 billion in liabilities related to repurchase agreements, according to Barclays analysts. About 80 percent of such repurchase trades are done against government collateral such as Treasuries and debt issued by government mortgage agencies.
Bank executives say the leverage ratio's treatment of repo books is particularly galling because the Treasury bonds banks will have to hold capital against are client assets, not the banks' own assets.
But the leverage ratio is not the only measure about to hit the repo market.
Already, the New York Fed is trying to defuse one of the riskiest practices in the market - the daily unwinding and rewinding of repo deals, through which brokerages, hedge funds, and other firms exchange collateral for short-term loans.
JPMorgan and Bank of New York Mellon are the two big custodian banks that hold the physical securities that are bought and sold in repo transactions. Each day, they lend the securities back to the banks for a few hours.
Should one of the borrowing banks land in trouble during the day, the custodian bank neither has the cash, nor the security, potentially leaving it doubly exposed.
Working with the two clearing banks, the Fed wants to cap intraday credit at 10 percent of a bank's book by the end of next year, and says it currently stands at 70 percent. The industry is improving systems to make the market more efficient, and investment banks are also increasingly borrowing more long-term debt, making them less dependent on intraday credit.
But as for the impact of the proposed supplementary leverage ratio, it means the banks will have an incentive to reduce their holdings of Treasuries and seek higher yields in other markets even if their risk profiles rise, the executives said.
"The (repo) market is very dislocated right now because of regulatory uncertainties," said Nancy Davis, a managing partner at hedge fund Quadratic Capital, who has worked at big banks as a senior derivatives trader. "I've never seen anything like it."
The repo market has recently been suffering from a shortage of Treasury bonds because of the U.S. Federal Reserve's massive bond buying program to stimulate the economy. Some repo rates that banks pay to investors to provide them with short-term cash have even turned negative, meaning investors in money market funds and asset managers now pay to hold the securities, rather than get money for lending cash.
"That business will shrink," an executive at one Wall Street bank said. Treasury bonds are "innocent bystanders, getting killed" by the regulators' action, he added.
Regulators said reforming the repo market remained a top priority, and that they would give markets sufficient time to adapt and avoid disruptions.
Banks still make widespread use of the repo market to raise short-term cash, refinancing billions of dollars every day. Regulators fear that leaves banks vulnerable to sudden collapse should counterparties become nervous about doing business with them for some reason, as repeatedly happened around the time of the financial crisis.
Regulators are also trying to address the problem of lack of data on the repo market, Fed Chairman Ben Bernanke has said.
The Office of Financial Research - a new unit that is part of the U.S. Treasury Department - wants to better understand the behavior of the market, see which market parties are exposed, and wants to know how market terms can change in periods of stress, both domestically and globally.
In September, regulators will tell politicians from the G20 leading world economies how they plan to reform shadow banking at a summit in Moscow. Detailed plans for keeping the repo market on a tighter leash are part of that agenda.
(Editing by Karey Van Hall, Paritosh Bansal and Leslie Gevirtz)