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Thursday, March 28, 2024

BIS Confirms Banks Use “Lehman-Style Trick” To Disguise Debt, Engage In “Window Dressing”

Courtesy of ZeroHedge. View original post here.

Several years ago we showed how the Fed’s then-new Reverse Repo operation had quickly transformed into nothing more than a quarter-end “window dressing” operation for major banks, seeking to make their balance sheets appear healthier and more stable for regulatory purposes.

As we described in article such as “What Just Happened In Today’s “Crazy” And Biggest Ever “Window-Dressing” Reverse Repo?”,Window Dressing On, Window Dressing Off… Amounting To $140 Billion In Two Days”, Month-End Window Dressing Sends Fed Reverse Repo Usage To $208 Billion: Second Highest Ever“, “WTF Chart Of The Day: “Holy $340 Billion In Quarter-End Window Dressing, Batman“, “Record $189 Billion Injected Into Market From “Window Dressing” Reverse Repo Unwind” and so on, we showed how banks were purposefully making their balance sheets appear better than they really with the aid of short-term Fed facilities for quarter-end regulatory purposes, a trick that gained prominence first nearly a decade ago with the infamous Lehman “Repo 105.” 

And this is a snapshot of what the reverse-repo usage looked like back in late 2014:

Today, in its latest Annual Economic Report, some 4 years after our original allegations, the Bank for International Settlements has confirmed that banks may indeed be “disguising” their borrowings “in a way similar to that used by Lehman Brothers” as debt ratios fall within limits imposed by regulators just four times a year, thank to the use of repo arrangements.

For those unfamiliar, the BIS explains that window-dressing refers to the practice of adjusting balance sheets around regular reporting dates, such as year- or quarter-ends and notes that “window-dressing can reflect attempts to optimise a firm’s profit and loss for taxation purposes.” 

For banks, however, it may also reflect responses to regulatory requirements, especially if combined with end-period reporting. One example is the Basel III leverage ratio. This ratio is reported based on quarter-end figures in some jurisdictions, but is calculated based on daily averages during the quarter in others. The former case can provide strong incentives to compress exposures around regulatory reporting dates – particularly at year-ends, when incentives are reinforced by other factors (eg taxation).”

But why repo? Because, as a form of collateralised borrowing, repos allow banks to obtain short-term funding against some of their assets – a balance sheet-expanding operation. The cash received can then be onlent via reverse repos, and the corresponding collateral may be used for further borrowing. At quarter-ends, banks can reverse the increase in their balance sheet by closing part of their reverse repo contracts and using the cash thus obtained to repay repos. This compression raises their reported leverage ratio, massaging their assets lower, and boosting leverage ratios, allowing banks to report them as being in line with regulatory requirements.

So what did the BIS finally find?  Here is the condemning punchline which was obvious to most back in 2014:

“The data indicate that window-dressing in repo markets is material”

The report continues:

Data from U.S. money market mutual funds point to pronounced cyclical patterns in banks’ U.S. dollar repo borrowing, especially for jurisdictions with leverage ratio reporting based on quarter-end figures (Graph III.A, left-hand panel). Since early 2015, with the beginning of Basel III leverage ratio disclosure, the amplitude of swings in euro area banks’ repo volumes has been rising – with total contractions by major banks up from about $35 billion to more than $145 billion at year-ends. Banks’ temporary withdrawal from repo markets is also apparent from MMMFs’ increased quarter-end presence in the Federal Reserve’s reverse repo (RRP) operations, which allows them to place excess cash (right-hand panel, black line).

This is problematic because this central-bank endorsed mechanism “reduces the prudential usefulness of the leverage ratio, which may end up being met only four times a year.” Furthermore, the BIS alleged that in addition to its negative effects on financial stability, the use of repos to game the requirement hinders access to the market for those who need it at quarter end and obstructs monetary policy implementation.

In other words, to help banks appear healthier than they are for regulatory purposes, central banks are essentially diluting the impact of their own monetary policy.

This is hardly a new development, and as we explained in 2014, one particular bank was notorious for its use of similar sleight of hand: as Bloomberg writes, the use of repo borrowings is similar to a “Lehman-style trick” in which the doomed bank used repos to disguise its borrowings “before it imploded in 2008 in the biggest-ever U.S. bankruptcy.”

The collapse prompted regulators to close an accounting loophole the firm had wriggled through to mask its debts and to introduce a leverage ratio globally.

How ironic, then, that it is central banks’ own financial operations with bank counterparties, that make a mockery of any macroprudential regulation attempts by central banks, and effectively exacerbate the problems in the financial system by implicitly allowing banks to continue masking the true extent of their debt.

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