FRANKFURT (Reuters) - Banks' "unconstrained" ability to generate credit by pledging the same assets as collateral multiple times needs to be curbed or risks creating a new financial bubble, the vice president of the European Central Bank said on Thursday.
Vitor Constancio's remarks underscored the ECB's concerns about the prospect of a new boom in lending between financial firms at a time when its own ultra-easy monetary policy boosts banks' ability to extend credit and investors' appetite for risk.
But they irked the industry, where some bankers and fund managers have complained about a scarcity of high-rated bonds to swap for cash in so-called repurchase agreements, or repos, as a result of stricter rules and massive ECB purchases of that paper.
Constancio warned against attempts to exclude repos from the calculation of banks' leverage ratio, the broadest measure of how much risk they are allowed to take against the capital they have.
"One area that still lacks reform concerns re-hypothecation and re-use of collateral," Vitor Constancio told an ECB conference.
"There is a push to exclude repos from the leverage ratio calculation under way that not only weakens the standard but also eliminates the only brake to banks’ capacity to the unconstrained creation of inside liquidity."
He added that recent initiatives by the Financial Stability Board, the international body that monitors and makes recommendations about the global financial system, were not going far enough and international attempts to tackle this issue had stalled.
Repo is a 3 trillion euros (£2.53 trillion) market in Europe and has become a key source of short-term funding for banks and other financial firms since the financial crisis, as appetite for unsecured lending, where cash changes hands without collateral, dissipated.
Industry body the International Capital Market Association said constraints on that market should be eased rather than tightened.
"Short term funding is the tool that underpins the well being of the real economy," ICMA's Godfried De Vidts said on the sidelines of the ECB conference.
"Current attempts to re-calibrate constraints on the use of repo should be actively pursued, not curtailed as some policy makers are suggesting."
ICMA has called for European regulators to ease their own rules and for the ECB, which sits on some 1.5 trillion euros worth of government bonds bought as part of its efforts to boost inflation, to lend out more bonds.
Global banking regulators on the Basel Committee have been working on new rules, including about the leverage ratio, since the 2007-2009 crisis but an agreement has proven elusive.
In the meantime, stress has been piling up in the repo market, where investors have struggled to source high-rated European government bonds at key junctures, such as the end of the year or quarter.
Failure to come up with collateral when asked can lead to a firm being put into default, with potentially destabilising consequences for the financial system as a whole.
Editing by Toby Chopra and Ed Osmond