REPO Transactions

Did you know that there is an extremely active market in which banks borrow from (lend to) each other overnight? This market is called the . Banks usually borrow in this market for one of two reasons:
1. They have reserves shortage and borrow in order to reach the reserves ratio required by the FRB (currently, this ratio (reserves to demand deposits) is 10%.
2. When they need to respond to customers' cash needs immediately and simply don't have the money.

One of the most important tools available to the FRB in controlling the money supply in the economy is by intervening in this market. For example: If the FRB aims at increasing the money supply, it should lend money to say security dealers. This loan is made by crediting they accounts in their commercial banks. Banks have now more money to lend and the money supply goes up. To contract the money supply, the FRB will call back such loans. Let's look at the cash flow associated with such a loan:



The problem is that the dealer in the above transaction may default on her loan. The Fed therefore needs some collateral. This is achieved by tailoring this loan as a repurchase agreement:



Note that if the security dealer fails to repay the loan on Tuesday (by repurchasing the securities from the FRB for $10,001,100), the FRB keeps the securities “sold” to it on Monday.

Exercise:
Do you see the similarity between this repurchase agreement and the “forward” transaction executed between Goldman Sachs and in Example 3.7 in the book? (page 89).