Lehman Brothers 'repo 105' revisited

It is almost ten years since that moment in 2008 when Lehman Brothers went down. There were a great many issues but one, 'repo105', taught us about the high risk strategy that some large financial institutions use. Perhaps, worth revisiting now that times seem better and financial institutions are growing again.

Financial institutions like banks (but also others like insurance, trust, etc.) frequently have two characteristics that differentiate them from industrial companies, though I appreciate the risk of generalities. First, they often become quite large. Second, they operate with leverage ratios that are quite higher than many other industries. There are sound economic reasons for both of these characteristics but they also bring with them potentially, large risks if not managed in a prudent manner. We all know about the 'too big to fail issue' that we have been grappling with since 2008. But there is another important risk that can be more difficult to see from the outside.

What do Continental Illinois, Norther Rock and Lehman Brothers all have in common - apart from the fact they all went bust? They all used a severe 'gap funding' strategy. At the extreme (and these firms did use it to the extreme), you raise your deposits in the overnight market to fund (much) longer term assets. You have a serious maturity mis-match between your assets and liabilities. On the funding side, you are literally going to the market every single day just to keep your firm alive. If the market becomes nervous about 'your name', or inter-bank funding dries up, you may be out of business - tomorrow morning. And, if you are a big financial institution then this can have very disruptive effects on your customers, employees, depositors, even the market as a whole.

It can be tempting to use a 'gap strategy' to some extent. Prior to 2008, and returning now, yield curves generally have a positive slope so paying out 1-day rates is less cost than what you are charging on longer term assets. But enhancing 'spread' comes at the risk of an increasing maturity mis-match. When time are good, it can really enhance a financial institution's bottom line. But if markets become nervous, well...

Almost any large financial institution is active in the inter-bank market to some extent and all watch carefully their counterparty risk to ensure those they provide liquidity to will still be there tomorrow morning. And institutions often see problems arising more quickly than the general public, who are also depositors or creditors. One first warning sign is when an institution starts paying higher levels for its money (deposits or other investment offerings) - this is a sign that the institutional market may be getting nervous. But, conversely, this seems like a good deal to the public, switch their money to that institution because they are paying (or sometimes saying 'guaranteeing') this higher return. And this may allow the institution to raise a lot more in deposits from the public. But higher return means higher risk and either due to lack of education or public disclosure, the public miss this - or are just tempted by the higher return.

There are very good reasons why financial institutions are subject to much regulation. First, they play an important role in the development of the economy, local industry and personal financial management. Second, they are very large and often take much of the public's money as deposits or otherwise. And, further to point 2., the public does not really understand risk and return or have the ability to do financial analysis on the institutions they trust their deposit money with. That is why effective regulation and oversight is essential in the financial industry.

Have we fully (or largely) recovered from 2008? Macreconomic variables seem more positive in many parts of the world. Growth seems to be taking off and new, large financial institutions are growing again. Hopefully, in the foreseeable future, we won't have a 4th big name to tag after Continental Illinois, Northern Rock and Lehman Brothers.

As an aside, for anyone that wants an in-depth review of the 'repo 105' issue, then I encourage you to read the below article from 2010 by the New York Times.

https://dealbook.nytimes.com/2010/03/12/the-british-origins-of-lehmans-accounting-gimmick/