The (sizable) Role of Rehypothecation in the Shadow Banking System [View all]

[dkf]

The United Kingdom provides a platform for higher leveraging stemming from the use (and re-use) of customer collateral. Furthermore, there are no policy initiatives to remove or reduce the asymmetry between United Kingdom and the United States on the use of customer collateral. We show that such U.K. funding to large U.S. banks is sizable and augments the measure of the shadow banking system. Supervisors of U.S. banks that report on a global consolidated basis need to enhance their understanding of the collateral funding that the U.S. banks receive in the United Kingdom.

Rehypothecation occurs when the collateral posted by a prime brokerage client (e.g., hedge fund) to its prime broker is used as collateral also by the prime broker for its own purposes. Every Customer Account Agreement or Prime Brokerage Agreement with a prime brokerage client will include blanket consent to this practice unless stated otherwise. In general, hedge funds pay less for the services of the prime broker if their collateral is allowed to be rehypothecated.

There has been very little research in this area. One of the first papers on this topic showed how the collapse in rehypothecation levels was contributing to global deleveraging after Lehman’s demise (Singh and Aitken, 2009a). Adrian and Shin (2009) provide an analytical model where collateral assets can be recycled by pledging and re-pledging; the model shows that during a crisis, the cumulative haircuts (or ‘margin spiral’) on pledged collateral can be sizable. Gorton (2009) shows that during a crisis, haircuts on collateral can result in a run on the shadow banking system. Singh and Aitken (2009b) show that counterparty risk during and in the aftermath of the recent crisis resulted in a decrease of up to $5 trillion in high- grade collateral due to reduced rehypothecation, decreased securities lending activities and the hoarding of unencumbered collateral.

This paper contributes to the ongoing policy debate on the size of the shadow banking system and how it impacted the funding for large banks. We show that in addition to the previously documented research (Adrian and Shin, etc.), that the shadow banking system was at least
50 percent larger than previously estimated. We also provide estimates from the hedge fund industry and their prime brokerage relationships with large banks for the “churning” or the extent of re-use of collateral. The rest of the paper is organized as follows. Section II discusses rehypothecation in the United Kingdom and the United States and the associated regulatory regimes; the United Kingdom provides a platform for higher leveraging (and deleveraging) not available in the United States. Section III highlights the collapse in rehypothecation levels in the United States, especially after the demise of Lehman. Section IV shows that the shadow banking system in the United States was much larger than envisaged, if we adjust for rehypothecation. Section V calculates the ‘churning’ factor for pledged collateral via hedge fund’s relationships with their prime brokers. Section VI concludes with some suggestions for regulators to enhance their understanding of the funding sources for large banks.

http://www.imf.org/external/pubs/ft/wp/2010/wp10172.pdf