Jake Miller
Repurchase agreements, or repos, are transactions in which a financial asset is transferred from a transferor to a transferee in exchange for cash. The transferor then enters into an agreement to reacquire the asset at a specified future date for an amount equal to the cash value plus interest. These agreements are often used by banks and financial institutions to finance their securities inventories, obtain short-term funding, and meet regulatory requirements. While repos can impact a bank's balance sheet, the specific accounting treatment may vary depending on the jurisdiction and the nature of the transaction. In some cases, assets sold in repos may be temporarily removed from the balance sheet, while in other cases, they may remain on the balance sheet but be reclassified as 'collateral'. The impact of repos on a bank's balance sheet can be complex and depend on various factors, including the specific terms of the agreement and the applicable accounting standards.
| Characteristics | Values |
|---|---|
| Do repos count against bank balance sheets? | Yes, repos count against bank balance sheets. |
| How are repos reflected in balance sheets? | Repos are reflected as secured borrowings in balance sheets. |
| Why are repos included in balance sheets? | Balance sheets are intended to measure the economic substance of transactions, not the legal form. |
| Are there any exceptions to including repos in balance sheets? | In the US, repos were temporarily removed from balance sheets under specific accounting provisions, but these options are no longer available. |
| How are repos classified in balance sheets? | International Financial Reporting Standards (IFRS) require repos to be reclassified from 'investments' to 'collateral' and balanced by a 'collateralised borrowing' liability. |
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What You'll Learn
Repo agreements are considered secured borrowings
Repurchase agreements, commonly known as repos, are considered secured borrowings. They are transactions in which a financial asset, typically a high-quality debt security, is transferred from a transferor to a transferee in exchange for cash. The transferor then enters into an agreement to repurchase the security at a specified future date for an amount equal to the initial cash amount plus interest. This transaction is essentially a short-term, collateral-backed loan, with the buyer acting as a short-term lender and the seller as a short-term borrower.
Repos are commonly used by banks, dealers, financial institutions, and corporate investors to finance their securities inventories, obtain short-term funding, and meet regulatory requirements. The term of a repo is flexible and can be adjusted as needed, making it a convenient tool for short-term borrowing and lending.
In a typical repo transaction, the transferor sells a security, such as a government bond, and agrees to buy it back at a slightly higher price soon after, usually overnight. The small price difference represents an implicit overnight interest rate, making repos particularly useful for raising short-term capital.
The collateral in a repo agreement remains on the balance sheet of the seller, even though legal title to the collateral has been transferred to the buyer. This is reflected in the International Financial Reporting Standards (IFRS), which require that securities out on repo be reclassified on the balance sheet from 'investments' to 'collateral', balanced by a 'collateralised borrowing' liability.
The US Federal Reserve also uses repos to regulate the money supply and bank reserves, as well as to manage overnight interest rates. Repos are considered safe due to the use of securities, such as Treasury bonds, as collateral.
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Repo agreements and bank reserves
Repurchase agreements, commonly known as repos, are a form of short-term secured borrowing. They are typically used to raise short-term capital and are often used in central bank open market operations. In a repo transaction, a dealer sells securities with an agreement to repurchase them at a higher price at a later date. This transaction facilitates liquidity and capital management for financial entities, with implied interest rates playing a critical role. The Federal Reserve uses repos to regulate the money supply and bank reserves.
When the Federal Reserve wishes to add to bank reserves, it can buy government securities with a forward commitment to sell them back. This is known as a repo because the Fed counterparty is borrowing money. Conversely, when the Federal Reserve borrows funds to drain reserves, it sells a government security with a commitment to buy it back in the future, known as a reverse repo because the dealer counterparty to the Fed is lending money.
Repos are used by banks, dealers, financial institutions, and corporate investors to finance their securities inventories, obtain short-term funding, and meet regulatory requirements. They are also used to finance long positions in the securities posted as collateral, obtain access to cheaper funding costs for long positions in other speculative investments, and cover short positions in securities via a reverse repo and sale.
In terms of accounting, repos are treated as purchases, and the collateral remains on the balance sheet of the seller. However, the securities out on repo are reclassified on the balance sheet from 'investments' to 'collateral' and are balanced by a specific 'collateralised borrowing' liability. The gain or loss arising from a repo transaction is included in earnings, but the classification of these amounts should conform to the characterization of the underlying transfer.
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Repo agreements and counterparty credit risk
Repurchase agreements, or "repos", are transactions in which a financial asset is transferred from a transferor to a transferee in exchange for cash. The transferor also agrees to reacquire the asset at a specified future date for the price of the cash received plus interest. Repos are commonly used by banks, dealers, financial institutions, and corporate investors to finance their securities inventories, obtain short-term funding, and meet regulatory requirements.
While repos can be beneficial, they are not risk-free financial instruments. The primary exposure in a repo is counterparty credit risk. Repos function as collateralized debt, which reduces the total risk, but does not eliminate it. The creditor in a repo bears the risk that the debtor will not repay the principal, just as in any loan. The choice of collateral is important in mitigating this risk. The credit risk on the collateral should have minimal correlation with the credit risk on the repo counterparty to diversify credit exposure. Additionally, the collateral should have minimal credit and liquidity risks to maximize certainty about its value and ease of liquidation in the event of a default. Government bonds have traditionally been used as collateral that meets these criteria.
To further reduce counterparty credit risk, careful selection of counterparties is vital. Collateralization does not change the probability of default by a counterparty, so collateral from risky counterparties may be worth less than expected due to price fluctuations, the impact of liquidation, and possible legal and operational problems. Proper securitization practices and safekeeping duties performed by a third-party custodian can also help protect the securities in a repo transaction.
Another way to mitigate counterparty credit risk is through over-collateralization. In this case, if the collateral falls in value, a margin call will require the borrower to amend the securities offered. Under-collateralization can be used if it seems unlikely that the creditor will sell the security back to the borrower. The longer the term of the repo, the more likely it is that the collateral securities' value will fluctuate before repurchase, affecting the repurchaser's ability to complete the contract. Therefore, shorter-term contracts are recommended to reduce counterparty credit risk.
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Repo agreements and income statements
Repurchase agreements, commonly referred to as "repos", are transactions in which a financial asset is transferred from a transferor to a transferee in exchange for cash. The transferor also agrees to repurchase the asset at a specified future date for an amount equal to the cash received, plus interest. Repurchase agreements are often used by banks, dealers, financial institutions, and corporate investors to finance their securities inventories, obtain short-term funding, and meet regulatory requirements.
The classification of gains or losses arising from a repurchase agreement in the income statement depends on the characterization of the underlying transfer. For example, the cost associated with a repurchase agreement accounted for as financing should be classified as an interest expense in the transferor's income statement. Conversely, companies that sell non-interest-bearing trade accounts receivable may characterize the resulting loss as a loss on sale, even though a component of that loss may be attributed to the investor's financing cost.
In a custodial or tri-party arrangement, control over the assets is not surrendered, and a reclassification of securities is not required as the transferee does not have the right to pledge or sell the collateral. However, the collateral remains on the balance sheet of the seller, even after the legal title to the collateral has been transferred to the buyer. To ensure clarity, the International Financial Reporting Standards (IFRS) require that securities out on repo are reclassified on the balance sheet from 'investments' to 'collateral' and are balanced by a 'collateralised borrowing' liability.
Repurchase agreements are generally considered low-risk transactions. The primary risk is that the seller may fail to repurchase the securities at maturity, in which case the security buyer may be forced to sell the security for a loss if the security value declines after the initial sale.
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Repo agreements and the economic substance of transactions
A repurchase agreement, also known as a "repo", is a form of secured short-term borrowing, usually using government securities as collateral. A contracting party sells a security to a lender and, by agreement between the two parties, repurchases the security back shortly afterward at a slightly higher contracted price. The difference in the prices and the time interval between the sale and repurchase creates an effective interest rate on the loan.
Repos are economically similar to secured loans, with the buyer (the lender or investor) receiving securities for collateral to protect against default by the seller. The party who initially sells the securities is effectively the borrower. The transaction is similar to a loan, but the terminology differs: the seller legally repurchases the securities from the buyer at the end of the loan term.
In a tri-party repo, a third party facilitates elements of the transaction, typically custody, escrow, monitoring, and other services. The securities are held by a custodian (usually a clearing bank), subject to an agreement signed by all three parties to the transaction. The transferor cannot obtain the collateral until they pay the transferee the amount owed under the contract (the collateral's repurchase price), thus providing security to the transferee in the event of default by the transferor.
In the US, repos have been used since as early as 1917 when wartime taxes made older forms of lending less attractive. At first, repos were used just by the Federal Reserve to lend to other banks, but the practice soon spread to other market participants. The use of repos expanded in the 1920s, fell away through the Great Depression and WWII, then expanded again in the 1950s, enjoying rapid growth in the 1970s and 1980s, in part due to computer technology.
The Federal Reserve uses repos and reverse repos to conduct monetary policy. When the Fed buys securities from a seller who agrees to repurchase them, it is injecting reserves into the financial system. Conversely, when the Fed sells securities with an agreement to repurchase, it is draining reserves from the system. The Fed's repo involvement has significantly increased the repo market's size, and it's unknown if the private sector could adjust to handle much higher volumes in the future.
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Frequently asked questions
A repo, or repurchase agreement, is a transaction in which a transferor transfers a financial asset to a transferee in exchange for cash. The transferor then enters into an agreement to reacquire the security at a specified future date for an amount equal to the cash received plus interest.
Assets sold as collateral in a repo remain on the balance sheet of the seller, even though legal title to those assets has been transferred. This is because the seller is committed to buying back the collateral at the original price plus repo interest, meaning they retain the risk and return on the collateral.
Repos are commonly used by banks, dealers, other financial institutions, and corporate investors to finance their securities inventories, obtain short-term funding, and/or meet regulatory requirements. They offer a flexible term compared to other short-term financing arrangements.
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