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FRM Part II · FRM Exam Part II · Repurchase Agreements and Financing

A regulator introduces minimum haircut floors for non-centrally cleared securities financing transactions to limit procyclical leverage. Which outcome is the most plausible, and the main residual concern, of such a floor?

Minimum haircut floors limit the scope for haircuts to be set too low in benign markets, curbing procyclical leverage, but activity can migrate to unregulated entities or jurisdictions. They do not prevent haircuts from rising in stress, so they do not eliminate run risk or the need for liquidity buffers.

  1. AIt reduces the scope for haircuts to be set too low in good times, but it can shift activity to jurisdictions or entities outside the rulesCorrect
  2. BIt eliminates all run risk in repo because haircuts can no longer change
  3. CIt lowers financing costs for all borrowers by increasing the cash raised per unit of collateral
  4. DIt removes the need for liquidity buffers at dealer banks

Explanation

Floors constrain leverage build-up when market haircuts are compressed, limiting procyclicality. They do not stop lenders from raising haircuts above the floor in stress, nor do they remove the need for buffers, and they can encourage regulatory arbitrage. Floors lower cash per collateral, not raise it.

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