The repo market under Basel III: Effects of capital and liquidity regulations on market fragmentation

Regulatory requirements can affect banks' ability and willingness to intermediate in financial markets. Yet, evidence on how these requirements interact to affect bank behaviour is thin. We contribute by assessing the effects of Basel III regulatory ratios on financial market fragmentation using the UK repo market as an important case study. Using panel regressions with proprietary data on repo transactions and holdings backed by gilts and lower-quality collateral, we find affirmative evidence of a fragmentation. The leverage ratio incentivises banks to net transactions which leads to a fragmentation across prices between netted and non-netted trades. Central bank liquidity can ease market conditions during stress and benefit banks that use it and their counterparties via reduced prices. In addition, the liquidity coverage ratio incentivises banks to increase long-term lending backed by gilts, but reduce lending backed by lower-quality collateral. This results in a fragmentation across maturities.