Ultra-loose Fed policy increases bank funding risk

In his Wall Street Journal Heard on the Street column, David Reilly concludes that the banks' heavy reliance on funding through repurchase agreements raises their risk and highlights why investors have to pay attention to the liability side of each bank's balance sheet.

This conclusion confirms why banks should be required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.  This is exactly the information that is needed to monitor bank funding risk.

What happens in the shadows doesn't always stay there. 

Part of the reason regulators continue to be so focused on the "shadow-banking" system—lending and investing activities that are banklike but operate outside the regulated financial system—is because it is often connected to the activities of regular banks.... 

Because banks and shadow-banking entities provide funds to each other through loans and financial products, such growth creates systemic risks as distress in one area "may easily spill over" to the other... 

And in some cases, the interconnections may be rising because of the superlow interest-rate environment. 

With bank profits being squeezed, many firms are looking to reduce their long-term debt, since this tends to be more expensive than shorter-term funding. 

In its place, banks rely more on short-term funding such as deposits, which have been soaring. But they are also increasing their use of short-term, repurchase, or repo, transactions. These involve a bank or investor borrowing or lending money on a short-term basis using securities as collateral. 

Indeed, among the biggest U.S. banks, repo financing is now almost as large as long-term debt outstanding. At the end of the third quarter, for example, combined long-term debt at J.P. Morgan Chase, JPM +2.68% Bank of America BAC +4.06% andCitigroup C +3.20% exceeded combined repurchase-agreement liabilities by just $44 billion. A year earlier, the difference was nearly $300 billion. 

The risk of rising dependence on repo financing is that any market disruption, say by the failure of an unregulated shadow entity, could ripple through regulated banks and create funding problems. 

In this, the [Financial Stability Board] is right to call for greater disclosure and transparency around these markets and the level of interconnections. 

Investors tend to focus on bank assets and the prospect for losses there. But with aggressive Federal Reserve policies starting to cause financial distortions, they need to keep just as close an eye on bank liabilities and how they are changing.

Which is why the banks should be required to provide ultra transparency and disclose their exposure details.