Over many years of facilitating our banking training programs, we’ve noticed that repurchase agreements can be intimidating for both accountants and auditors. However, repos aren’t all that confusing when you break them down and understand why entities enter such transactions, and that’s what we’ll cover in this blog.
This blog is Part 1 of our two-part series on repurchase agreements. Next week we’ll post Part 2, where we’ll discuss the accounting requirements under ASC 860, Transfers and Servicing and walk through an example.
Who uses repurchase agreements?
Do you need some fast cash for a short time period? A repurchase agreement may be your solution. Is your entity’s piggy bank full? You might benefit from a reverse repurchase agreement. An agreement that can help those needing cash and those with excess cash at the same time?! You may be saying “when pigs fly!” but let me explain how repurchase agreements work and why they’re a common solution for a bank’s funding requirements.
What is a repurchase agreement?
Repurchase agreements are frequently used by banks as a funding source for short-term cash needs, while reverse repurchase agreements are used by banks to earn a return on idle cash. A repurchase agreement, or “repo,” is the sale of a financial asset (we’ll use securities as our asset for our discussion today) together with an agreement for the seller to repurchase the financial asset (buy back the securities) at a later date. The repurchase price will be greater than the original sale price, with this difference in price effectively representing the interest (sometimes called the repo rate). The party that originally buys the securities (and gives the cash) acts as a lender. The original seller of the securities acts as a borrower, using their securities as collateral for a secured cash loan at a fixed rate of interest obtained from the lender.
Clear as mud, right?! Check out the video from our Deposits and Other Funding Sources eLearning course below to see a visualization of repos and reverse repos function between two hypothetical banks – Wilbur Bank and Babe Financial.
Why would either party enter into a repurchase agreement?
In most cases the reason is for short-term financing. One entity, the seller/borrower, (Wilbur Bank in the video) may have a need for cash, while the other entity, the buyer/lender, (Babe Financial in the video) has excess cash. The securities sold by the seller/borrower are simply collateral to protect the buyer/lender’s loan. The fair value of these securities is typically higher than the cash lent. This overcollateralization protects the buyer/lender from decreases in fair value of the securities from the time they were sold until the time the seller/borrower buys them back.
What’s in it for both parties?
For the borrowing entity (Wilbur), they get much needed cash on a short-term basis and at a relatively cheap price since they are borrowing on a collateralized basis. For the lending entity (Babe), they are able to charge interest and earn a return on otherwise excess uninvested cash, while being protected from credit risk since the securities have been put up as collateral.
Remember-- the repurchase price of the securities is always “higher” than the original sales price. This is essentially the “interest” paid by the seller/borrower to the buyer/lender.
At first thought, it may seem like an awful lot of work for fractions of a percent over a very short time period. However, since these transactions are usually based on high dollar value amounts (potentially millions of dollars), these fractions of a percent add up quickly! Additionally, from the perspective of a buyer/lender bank, the repo rate is generally a bit higher than the federal funds rate. Therefore, for minimal risk, the buyer/lender receives a better return than just leaving their money with the Federal Reserve.
What are the potential issues to be considered?
While this may appear to be a relatively safe transaction, it is a one-on-one transaction and therefore both parties are exposed to credit risk. Although collateral has been put up to minimize this risk, there still is the possibility that the fair value of the collateral changes significantly, putting either party at risk of being exposed should the other party default at settlement. Therefore, it is important to ensure collateral levels are maintained and monitored throughout the period of the agreement to ensure credit risk is minimized. In addition, the term of repos is generally short, which also helps to minimize this risk.
The accounting for repurchase agreements depends on whether the transaction is deemed to be a sale or a secured borrowing. ASC 860, Transfers and Servicing addresses the transfers of financial assets and provides guidance. In Part 2 of this blog next week, we’ll explore the accounting treatment and walk through example journal entries.
U.S. GAAP for banks
The information from today’s blog is just a snippet from our Deposits and Other Sources of Funding eLearning course. Are you searching for more help when it comes to U.S. GAAP for banks? Check out our Banking Industry Fundamentals Course Collection! We’ve bundled together 9 online, eLearning courses totaling 11.5 CPE credits covering topics specific to banks! Check out this post for an overview of the courses in the collection.
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