Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Prudent at night but reckless during the day

I have been thinking a lot about what the court examiner’s
on Lehman tells us about other banks. Looking at many
things mentioned in the report, my conclusion is that even the banks
that are prudent at night become quite reckless during the day. Banks
that are careful about their end of day (overnight) exposures seem to
be happy to assume very large exposures during the day provided they
believe that the position will be unwound before close of the day.

My first example of this phenomenon is a repo transaction
undertaken by Barclays after it bought a major part of the Lehman
broker dealer business (LBI) in the bankruptcy court. The examiner
describes this transaction and its consequences in detail in his

The parties then began to implement … a repo transaction between
LBI and Barclays under which Barclays would send $45 billion in cash
to JPMorgan for the benefit of LBI, and Lehman would pledge securities
to Barclays. Barclays planned to wire the $45 billion cash to JPMorgan
in $5 billion components, and Barclays (actually, Barclays’
triparty custodian bank, BNYM) would receive collateral to secure each
$5 billion cash transfer. (Page 2165, Volume 5)

Shortly after noon on Thursday, Barclays wired the initial $5
billion of cash to JPMorgan for the benefit of LBI. (Page 2166, Volume

… a senior executive from JPMorgan then contacted Diamond,
and asked Barclays to send the $40 billion in cash all at once to
expedite the process. According to Ricci, the JPMorgan executive
provided Diamond with assurances that, if Barclays sent the $40
billion in cash, JPMorgan would follow up promptly in delivering the
remaining collateral. Early Thursday evening, Barclays wired the
remaining $40 billion in cash. Barclays did not receive $49.6 billion
in securities that evening. Although both the FRBNY and DTCC kept
their securities transfer facilities open long after their usual
closing times, by 11:00 p.m. on Thursday evening, September 18,
Barclays had received collateral with a marked value of only
approximately $42 billion. (Page 2167, Volume 5)

To put matters in perspective, $40 billion was roughly equal to the
total shareholders’ equity of Barclays at that time (according
to the June 30, 2008 balance sheet, shareholders’ equity was
£ 22.3 billion or $40.5 billion at the exchange rate of 1.82
$/£ on September 18, 2008). In other words, Barclays was willing
to take an unsecured intraday exposure to another bank equivalent to
roughly its entire worth. I am sure that an overnight unsecured
exposure of this magnitude would be regarded as reckless and
irresponsible, but an intraday position was acceptable.

My second example is the triparty clearing bank services provided
by JP Morgan Lehman and other broker-dealers. The examiner’s
report provides a lucid explanation of the whole matter:

In a triparty repo, a triparty clearing bank such as JPMorgan acts
as an agent, facilitating cash transactions from investors to broker-
dealers, which, in turn, post securities as collateral. The
broker-dealers and investors negotiate their own terms; JPMorgan acts
only as an agent. Triparty repos typically mature overnight … Each
night collateral is allocated to investors … The investors, in turn,
provide overnight … funding to the broker-dealer. The following
morning, JPMorgan “unwinds” the triparty repos, returning
cash to the triparty investors and retrieving the securities posted
the night before by the broker-dealer. These securities then serve as
collateral against the risk created by JPMorgan’s cash advance
to investors. During the business day, broker-dealers arrange the
funding that they will need at the close of business through new
triparty-repo agreements. This new funding must repay the cash that
JPMorgan advanced during the business day… (Page 1086-87, Volume

The premise of a triparty repo is that it constitutes secured
funding in which the lender (investor) has the opportunity to sell the
collateral immediately upon a broker-dealer’s (borrower’s)
failure to pay maturing principal. (Page 1092, Volume 4)

To guard against the possibility of the investor realizing less
than the loan amount in a liquidation scenario, the borrower must
pledge additional “margin” (i.e., additional collateral)
to the lender – for example, $100 million of Treasury securities
in exchange for $98 million in cash. (Page 1092, Volume 4)

As triparty-repo agent to broker-dealers, JPMorgan was effectively
their intraday triparty lender. When JPMorgan paid cash to the
triparty investors in the morning and received collateral into
broker-dealer accounts (which secured its cash advance), it bore a
similar risk for the duration of the business day that triparty
lenders bore overnight. If a broker-dealer such as LBI defaulted
during the day, JPMorgan would have to sell the securities it was
holding as collateral to recoup its morning cash advance. (Page 1093,
Volume 4)

Through February 2008, JPMorgan gave full value to the securities
pledged by Lehman in the NFE calculation and did not require a haircut
for its effective intraday triparty lending. Consequently, through
February 2008, JPMorgan did not require that Lehman post the margin
required by investors overnight to JPMorgan during the day. (Page
1094, Volume 4)

That last paragraph left me stunned. Why would the clearing bank
not impose a haircut/margin on the intraday secured lending, while
the repo lenders do require such a haircut on the overnight lending?
It makes no sense to me. First, the clearing bank is taking a large
concentrated exposure, while this exposure gets distributed over a
large number of overnight lenders. If anything, the intraday lender
should be more worried and should be charging a higher margin. Second,
most financial asset prices instruments are more volatile when the
markets are open than when they are closed. Since prices are expected
to change more during the day than during the night, the intraday
lender actually needs a higher margin. Yet, the intraday lender did
not ask for any margins at all till February 2008!

For a moment, I thought that the clearing bank was not charging
margins because it was willing to take some amount of unsecured
exposure to the broker-dealer and it was willing to dispense with the
margin under the assumption that the margin would be less than the
unsecured exposure that it was willing to have. But no, the
examiner’s report clearly states that the margin free secured
lending was over and above the maximum unsecured lending that JPMorgan
was willing to provide:

JPMorgan used a measurement for triparty and all other clearing
exposure known as Net Free Equity (“NFE”). In its
simplest form, NFE was the market value of Lehman securities pledged
to JPMorgan plus any unsecured credit line JPMorgan extended to Lehman
minus cash advanced by JPMorgan to Lehman. An NFE value greater
than zero indicated that Lehman had not depleted its available credit
with JPMorgan. (Page 1093, Volume 4)

Yet, on a reading of the entire examiner’s report, JPMorgan
comes across as a bank with a very robust risk management
culture. Again and again one sees that in the most turbulent of times,
the bank is seen to be sensitive to various market risks and
operational risks and appears to have taken corrective action very
quickly. The only conclusion that I can come to is that even well run
banks are complacent about intraday risks.

Why should banks be prudent at night but reckless during the day?
Probably this has got to do with the fact that nobody prepares
intraday balance sheets and so positions that are reversed before
close of day do not appear in any external reports (and probably not
in many internal reports either). Probably, it has to do with the
primordial fear of darkness dating back to our evolutionary struggles
in the African Savannah. As the biologists remind us, you can take the
man out of the Savannah, but you can not take the Savannah out of the


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