BoE published a working paper that analyzes the effects of the European Market Infrastructure Regulation (EMIR) and Basel III regulations on short-term interest rates. EMIR requires central clearing houses (CCP) to continually acquire safe assets, thus expanding the lending supply of repurchase agreements (repo). Basel III, in contrast, disincentivizes the borrowing demand by tightening balance-sheet constraints of banks. Using unique datasets of repo transactions and CCP activity, compelling evidence has been found for both supply and demand channels.
The analysis presented in the paper has been conducted based on two unique and granular datasets. The first dataset includes all Euro and Sterling repos traded in the three main interbank platforms (BrokerTec, Eurex Repo, and MTS Repo) and this dataset covers more than 70% of the total European repo market. The second dataset contains the reverse repo and bond investments of clearing houses, with reporting obligations to BoE from November 2013 to December 2017. Three main results emerge from the study:
- First, to conform to new regulation, clearing houses’ lending exerts a pervasive and systematic downward pressure on short-term rates. CCPs’ reverse repos to purchase EMIR-eligible assets significantly decrease short-term interest rates, thus supporting the supply hypothesis.
- Second, this effect increases during quarterly reporting dates, that is, when the Basel III leverage ratio imposes balance sheet constraints on banks demanding (but not lending) repos. This evidence suggests that the joint regulatory effects of EMIR and Basel III further decrease short-term rates, thus supporting the demand hypotheses.
- Third, it is found that regulatory-driven supply has significant adverse effects on price dispersion and lending volume. Supply induced by regulation increases the net supply of repos in the interbank market, the cross-sectional dispersion of short-term rates with strongest effects on the safest assets, and the time-varying forward discount. The overall effects are decreasing short-term rates and increasing market imbalances in various forms, all of which entail unintended consequences originated from the new regulatory framework.
Keywords: Europe, UK, Banking, Securities, Basel III, EMIR, CCP, Short-Term Interest Rates, Repo, Leverage Ratio, Research, BoE