Banking: US reform aims to end Lehman-style collapses

18th February 2011

Moody's view is reported here by the Financial Times.

The reform of the tri-party repurchase market, due to roll out this June, could mean we will not see a repeat of runs that led to Bear Stearns being sold for a mere fistful of dollars and the Lehman Brothers collapse.

Contagion from Lehmans provoked a series of global problems including in the UK as banks lost faith in their ability to pay each other back and in the collateral they were using to back any loans.

Under tri-party repurchase, one institution lends money for a short period of time and receives securities pledged as collateral, with a big US clearing bank – there are currently only two – Bank of New York and JP Morgan Chase – acting as custodian.

In the old system, banks unwound all outstanding repurchase trades each day, but this meant the clearing banks ended up extending trillions of dollars in credit to dealers.

During the crisis, financial institutions became reluctant to extend credit and rather than look at the quality of the collateral began to set great store on market sentiment and even market rumours about the credit worthiness of an institution.

Effectively other institutions began to refuse to lend or trade with Bear or Lehmans provoking their respective crises which then moved successively to other banks before national Governments around the world stepped in with financing and even nationalisation.

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