AMONG financial geeks, the repurchase market is seen as the lifeblood of a monetary system. Without it, banks cannot really operate.

China’s seized up on Tuesday, prompting the People’s Bank of China to perform an emergency cardiac massage. Other regulators in Beijing may want to look on closely, because they may be called upon to undertake a similar manoeuvre shortly.

To understand what happened in Asia’s largest economy, it is important to know how banks operate. Every so many hours, institutions tally up how much cash is coming in the doors and how much is going out. Unlike in the textbooks, this never nets out at zero. Enter the repo market. Banks with excess cash lend it to those that are short at a friendly interest rate. The borrowing bank also deposits some securities in treasury for the lending institution as a guarantee it will return the money tomorrow.

That kind of arrangement happens even when the central bank is the creditor. Remember when the US Federal Reserve said Lehman Brothers Holdings Inc did not have collateral to be used for additional liquidity when it let the investment bank collapse back in 2008?

Bankers are a suspicious lot by nature, and they suspect each other more than anyone else. When a rare default happens, they start hoarding cash, even if they know they can get their money back by selling some of the securities that were pledged. That is what is happening now in China.

China’s central bank on Tuesday injected hundreds of billions of yuan into the financial system after some smaller lenders failed to make debt payments in the interbank market, people familiar with the matter said. The interest rate on overnight borrowings soared 78 basis points from a week ago to 3.28%, making the yield to borrow for a single day higher than the 3.14% five-year Chinese government bonds pay (see chart — Madness).

That should normalise after a few liquidity injections — after all, nothing is more comforting than knowing the central bank has your back. This time, however, it may be more complicated, particularly if the missed payments are the start of a trend.

On Tuesday, it also transpired that the China Securities Depository and Clearing Corp, which oversees exchange-traded notes, plans to allow financial institutions to use only AAA-rated company securities as collateral for short-term loans. (In China, banks tend to be a bit more generous than their Western counterparts, which typically only accept their own government’s debt as collateral.)

One of the most recent times regulators tightened repo regulations was in December 2014, and the bond market pretty much froze. Then, banks were told they could only accept bonds rated AA or higher. That has since become something of a moot point: Thanks to the financial discipline of Chinese borrowers, about 95% of corporate debentures can be used as a guarantee for interbank borrowings.

The new requirement means at least half of these securities will no longer qualify. Whether that played a part or not in this week’s interbank defaults is not clear. But you can bet it will in future. — Bloomberg