Question

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Q2. (Repo and Financial Statements) Repo is a contract where a buyer buys an asset at X and sell it back to its seller at Y (Y>X) one day after. Therefore, this buy and sell it back at higher price is just like lending with a collateral (the asset being exchanged). Suppose that there is a bank that holds huge amount of risky bonds in its portfolio. Tomorrow, the bank has to report its financial statements to the public but the amount of risky bonds the bank currently holds is against the regulation on bank risk management. What the CEO of the bank chose to do is to initiate a large-scale repo contract and sell the risky bonds overnight and remove it from its balance sheet. When the reporting process is done, the bank will buy back those bonds. Do you think this is ethical? Based on this case, do you think when a firm engages in repo, we have to consider it as independent selling and buying back or lending with collateral? (The former means adjustments in total assets, the latter does not mean changes in total assets in general).

Answer 1

Repo contracts are only short term in nature. Therefore though this seems as a buy and sell transaction it is treated as lending with collateral in accounting terms. Since the buyer only has temporary ownership of the security, these agreements are often treated as loans for tax and accounting purposes. In the repo transaction the seller keeps the security on its books, adds the cash received to its assets and adds a loan to its liabilities. Hence the CEO of the bank cannot remove the risky bonds from the balance sheet if he initiates a large scale repo contract to exchange the risky bonds. That would be considered unethical. There are many accounting standards and disclosure norms a bank needs to adhere to for its financial reporting. These are specified by Basel III norms which is an international regulatory framework for banks. Based on the interpretation of a repo contract it is treated as a lending with a collateral and not independent selling/buying.