Dubai: Smaller Gulf banks, squeezed by difficult funding conditions and flush with bond paper following the busiest period of issuance from the region on record, are increasingly exploiting the repo market to raise capital.

The banks are using repurchase agreements — contracts in which a security, such as a bond certificate, is temporarily transferred to another holder during a set period in exchange for capital — to manage liquidity as other sources of funding dry up.

Bond issuance out of the Gulf Cooperation Council has totalled $91.5 billion (Dh336.046 billion) in the last three years, according to Thomson Reuters data, with much of the paper being issued by highly rated, state-linked entities.

With lending levels in the region falling away in recent months as a result of the European debt crisis, banks, the largest investor type in a part of the world which lacks developed insurance and asset management sectors, are increasingly using their holdings of this paper to access funds.

"The single most useful aspect of our balance sheet is the significant investment-grade bond book — of which around 80 percent is repoable," said one regional banker, who declined to be identified.

"In the last 12 months, we have done more repos than in the last ten years."

Repos come in two forms: short-term, for example lasting 90 days, and term repos, which can be for one or two years or the life of the bond. The rate at which the money is lent is usually much lower than the equivalent in the interbank or syndicated loan markets, since the lender has the security of the bond on its balance sheet — important when funding conditions are unfavourable.

"The interbank markets are dead right now so banks are looking at different things," the Dubai-based banker said.

"We use them as a backstop. They can help liquidity ratios as we can repo when needs be."

Smaller institutions

While larger regional institutions have been using the repo market for some years, it is the growing use of repos at smaller banks which has been noticeable in the last few months.

"There has been a big drive in repo activity, especially for GCC banks using them for the first time," the regional banker said, estimating around 50-60 per cent of banks in the region now used the repo market against near 10 percent a couple of years ago.

"I'm aware that some small GCC banks are buying US Treasuries for the pure purpose of repoing them," he added. This activity is being encouraged not only by the difficult funding conditions but also by two other factors.

"A lot of international banks are doing it [arranging] so the pricing is competitive," a second Dubai-based banker said.

"If the bonds are ECB- [European Central Bank] or Fed- [US Federal Reserve] eligible, then the lending bank can repo them directly with the central bank" if it wants to borrow money through market operations by those central banks, he added.

However, while repos can achieve lower funding costs for local banks, they can also limit the banks' room to manoeuvre. A borrower may want to exit a repo deal early but find that the lender has already used the bond in another repo transaction, which may not expire for some time. The borrower may then need to bear the cost of acquiring the bond from the market.

"You don't have control — you can exit the repo but the bank might have sold the bond," the first Dubai banker said.

The second factor encouraging repos is the increasingly flexible attitude of banks in the region towards their balance sheets, which includes a shift away from exclusively holding bonds as investments to term. The shift is due partly to financial pressures and partly to banks' growing sophistication.