Bank Repos or Repurchase Agreement
A bank repo or repurchase agreement is another good source of funds for banks.Â
Due to the interest rate restrictions on checking deposits placed by the Glass-Steagall Act banks were at a competitive disadvantage when interest rates rose,Â forcing themÂ toÂ create innovative products around these restrictions.
Understanding the Basics of a Repo
The bank would perform a bank repo with a loan customer by selling and buying government securities with the client for a short duration. Let’s take the case of the AAA client. AAA has a $1 million loan outstanding with Bank of Metrocity (BOM).
However, due to regulatory restrictions, BOM cannot pay interest on deposits to AAA. AAA and BOM enter into a bank repo where at the end of the day the deposit at BOM is converted into a secured loan. The loan is created by a sale of securities by BOM to AAA with a simultaneous buy back the next morning at a fixed price. The price is fixed depending on the interest rate that BOM wants to pay AAA.
Let us take an example to understand this further. Let’s assume that BOM wishes to pay AAA 6% on non utilized deposits
BOM sells AAA securities for $1 million overnight
Next morning BOM buys securities worth $1 million + 6% annualized
Assuming a day count convention of – actual/360 for repo transactions BOM buys back at – $1million + $167
The next day AAAâ€™s deposit is credited by $1,000,167. If the funds are unused by AAA then BOM and AAA enter into an overnight repo again for securities with this new amount.
This arrangement has huge benefits for BOM as well. Since required reserves are calculated as a percentage of deposits at the end of the day, the deposits at BOM are converted into securities sold each day before the close of the day, BOM can hold fewer reserves. At a reserve requirement of 10%, BOM can reduce its reserves by roughly $100,000. A repo transaction is considered a borrowing rather than a deposit hence escaping the reserve requirement.
The Reverse Repo Transaction
There is another concept that we need to understand when studying repos as we will come across it when studying the Fedâ€™s monetary policy is reverse repos. Basically, one party to a repo transaction is performing a repo and the other a reverse repo. A reverse repo transaction is when the bank wishes to borrow securities.
Let’s take the example of a bank called Centralbank performing a reverse repo transaction with Repobank. Centralbank purchases securities worth $100 million in a reverse repo and in turn credits Repobankâ€™s reserve account with cash worth $99.5 million. Even though the securities are worth $100 today they might not be the same market value when the securities are sold back.
This reduction of the cash value of the security taking into account market risk is called a haircut. If the transaction was a term repo with a tenor of 1 week, Centralbank sells the securities back to Repobank after a week at the $99.5 plus the interest rate (repo rate). From the Centralbankâ€™s point of view it’s a reverse repo transaction and from Rabobank’s point of view, it’s a repo transaction.
The repo and reverse repo transaction is an important concept to remember since the Fed uses this as a tool to implement its monetary policy that we will see soon.
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