Capital Market Development: China and Asia Seminar Series — Determinants of Repo Haircut: Counter-Party Risk and Collateral Risk

COLLABORATING ORGANIZERS

Repo market is an important source of wholesale funding for the financial institutions. Ever since Great Financial Crisis, repo haircut has been seen as a crucial barometer of the well-functioning of financial market. Theory predicts that repo haircuts increase with the collateral risk and counterparty risk. Using a proprietary transaction-level dataset from China’s interbank bilateral repo market, the authors empirically examine the determinants of repo haircut and test the theoretical predictions. It was found that haircut is increasing in both the default risk and the illiquidity risk of the collateral. The authors also find that haircut of the same collateral can differ across trading counterparties. Haircut on transaction between small banks which act as intermediaries in repo market are significantly lower than other transactions with the same collateral, implying that trading relationship may have an impact on haircut besides counterparty default risk. The authors exploit an unexpected event, the Baoshang Bank takeover, as a shock on the default risk of the intermediaries to explore the interplay of these factors during crisis episodes. The authors find that the takeover raised haircut for downstream institutions borrowing from intermediaries that are similar to Baoshang Bank. The increase in the counterparty risk further caused a cross-the-board increase in the haircut on low-quality collaterals, suggesting an information spillover effect. The authors further explore the dynamics of the haircuts during the COVID-19 outbreak. The authors find that the haircuts increased for illiquid- and pandemic-sensitive collaterals. The authors do not find evidence to support an increase in the counterparty risk during the pandemic.

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About the Seminar Series

Financial market development goes hand-in-hand with economic growth. The development of China’s capital markets in terms of size, regulations, capability, and efficiency has been impressive. China may now even lead globally in some dimensions, notably e-payments systems. Yet, China’s capital markets are still a work-in-progress facing both generic and unique challenges. Other Asian capital markets have even greater uneven development. Some in advanced Asian economies have acquired globally acclaimed reputation and capabilities while various regulatory and structural weaknesses dwarf others. Corporations and investors have been inclined to arbitrage cross-border regulatory and developmental gaps; so the very uneven status of capital markets across Asia is a policy issue for the governments in the entire region and perhaps globally. Analyzing the positive and negative lessons in the functioning of Asia’s capital markets, and identifying reforms and applications of technology that could further improve Asian capital markets’ allocation efficiency, financial inclusion, and forewarning against reforms that might cause problems can benefit practitioners, policymakers and researchers, and can contribute significantly to overall prosperity.

The ABFER and the University of Chicago’s Becker Friedman Institute China (BFI-China), in collaboration with National University of Singapore (NUS) Business School, Shanghai Advanced Institute of Finance (SAIF), The Chinese University of Hong Kong (CUHK) Department of Economics, CUHK-Shenzhen and Tsinghua University PBC School of Finance (Tsinghua PBCSF), hope to provide a virtual network to benefit researchers, policymakers, and practitioners from Asia and beyond.