Tuesday, October 27, 2009

Rehypothecation "driver of contagion" during crisis

Posted on Risk.net by Peter Madigan:

Rehypothecation of client assets was one of the “dominant drivers of contagion” during the financial crisis, amplifying the market turmoil in the wake of the Lehman Brothers collapse, the Senior Supervisors' Group (SSG) has concluded.

The body, consisting of financial regulators from the US, Japan, Germany, France, the UK, Canada and Switzerland, made the assertion in its Risk Management Lessons from the Global Banking Crisis of 2008 report, issued as a follow-up to its first survey published in March 2008. It noted that “many of the weaknesses highlighted in our first report continue to contribute to financial strains. Despite the passage of many months since our first survey, we found that a large number of firms had not fully addressed the issues raised at that time”.

The authors noted that, following the bankruptcy of Lehman Brothers International Europe (LBIE), clients that had elected to allow the dealer to rehypothecate their assets – the process by which a dealer lends out collateral posted by a client to another counterparty - found themselves caught in the bankruptcy as mere unsecured creditors to the estate, rather than having their assets preserved in segregated customer accounts.

As a result, counterparties that should not have been significantly affected by the collapse of the dealer found their assets trapped in the insolvency, shrinking their funding base and dragging a host of additional institutions into a precarious fiscal position, further deepening the crisis. LBIE’s administrators PricewaterhouseCoopers confirmed that more than $40 billion in hedge fund collateral had been swallowed in the collapse.

“Custody of assets and rehypothecation practices were dominant drivers of contagion, transmitting liquidity risks to other firms. The loss of rehypothecated assets and the “freezing" of custody assets created alarm in the hedge fund community and led to an outflow of positions from similar accounts at other firms. Some firms’ use of liquidity from rehypothecated assets to finance proprietary positions also exacerbated funding stresses,” the authors concluded.

The report focuses heavily on liquidity risk and capital management processes at institutions in seven of the world’s largest economies, and determined that firms continue to exhibit weaknesses more than 18 months after concerns were first raised by the SSG.

Paying particular attention to liquidity risk, the report notes that the institutions found to be most vulnerable during the crisis depended heavily on uninterrupted access to secured financing markets, and relied on excessive short-term and often overnight wholesale financing of long-term illiquid assets, a practice that made it difficult for the firms to withstand market turmoil without a deposit base to draw upon and central bank support.

Conversely, the institutions that weathered the storm much better were those that resisted taking advantage of short-term credit and were able to draw on other sources such as deposits, liquidity pools consisting of government bonds and central bank lending facilities.

The SSG also concluded that “considerable work” remains to be done in the areas of governance and internal controls. It blamed senior managers and directors for being unwilling or unable “to articulate, measure, and adhere to a level of risk acceptable to the firm,” and added that existing compensation plans often conflicted with the control objectives of the firm and favoured risk-takers at the expense of independent risk managers and control personnel.

The full report is available at: http://www.newyorkfed.org/newsevents/news/banking/2009/SSG_report.pdf.

No comments: