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The Run on Repo and the Policy Interventions to Struggle the Great Crisis

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Modern Financial Crises

Part of the book series: Financial and Monetary Policy Studies ((FMPS,volume 42))

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Abstract

At the core of the recent Great Crisis is the emergence over the last 35 years of the shadow banking system, which recreated in the USA the conditions for a panic. This time the panic firstly took place in the repo market, which suffered a run when “depositors” required increasing haircuts. Fears of insolvency reduced interbank lending, and this so-called run on repo caused temporary disruptions in the pricing system of short-term debt markets. The subsequent crisis reduced the pool of assets considered acceptable as collateral, resulting in a liquidity shortage. With declining asset values and increasing haircuts, the US banking system was effectively insolvent for the first time since the Great Depression. Finally, the policy interventions to struggle the crisis are briefly discussed.

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Notes

  1. 1.

    Does demand for safety create instability? Matta and Perotti (2015) answer to this question arguing that secured (repo) funding can be made so safe that it never runs but shifts risk to unsecured creditors. They show that this triggers more frequent runs by unsecured creditors, even in the absence of fundamental risk. This effect is separate from the liquidation externality caused by fire sales of seized collateral upon default. As more secured debt causes larger fire sales, it leads to higher haircuts which further increase the frequency of runs. While secured funding combined with high-yield unsecured debt may reduce instability, the private choice of repo funding always increases it. Regulators need to contain its reinforcing effect on liquidity risk, trading off its role in expanding funding by creating a safe asset.

  2. 2.

    This interpretation of the shadow banking system is extensively developed by Gorton (2009), Gorton and Metrick (2009b, 2012a), and Gorton and Ordonez (2012).

  3. 3.

    The shadow banking system includes all financial institutions such as money market funds, investment banks, hedge funds, insurance companies, mortgage companies, government-sponsored enterprises, and other financial intermediaries involved in facilitating the creation of credit across the global financial system, but whose members are not subject to regulatory oversight. The shadow banking system also refers to unregulated activities by regulated institutions, such as over-the-counter (OTC) derivatives and particularly credit default swaps (CDS). The essence of this term is to differentiate between those parts of the financial system that are visible to regulators and under their direct control and those which are not.

  4. 4.

    The process of banking deregulation that much contributed to the crisis began in October 1982, when President Ronald Reagan signed into Law the Garn-St. Germain Depository Institutions Act. In November 1999, President Bill Clinton signed into Law the Gramm–Leach–Bliley Act, which repealed part of the Glass–Steagall Act of 1933. This repeal has been criticized for reducing the separation between commercial banks, which traditionally had a conservative culture, and investment banks, which had a more risk-taking culture. Finally, in 2004, the Securities and Exchange Commission relaxed the net capital rule, which enabled investment banks to substantially increase the level of debt they were taking on. The role of institutions in explaining the recent financial crisis is analyzed by Shachmurove (2012).

  5. 5.

    With the advice of the president’s Working Group on Financial Markets, the Commodity Futures Modernization Act of 2000 allowed the self-regulation of the over-the-counter (OTC) derivatives market. Knight (2008) highlighted the key features of the turmoil as follows: the lack of transparency in the originate-to-distribute model (see the following footnote 6); the role played by credit rating agencies in the evaluation of structured products; and the covert reliance on special purpose vehicles to conduct off-balance sheet financial transactions on a large scale. The effect of all these influences was that when the “Minsky moment” came, perceptions of risky exposures, both to credit losses and to liquidity shortages, rose sharply, as did uncertainty about where those exposures might materialize. The “Minsky moment” refers to Minsky’s (1982) conviction that a new financial crisis was going to happen since the 1980s. On financial innovation, see Merton (1992), Tufano (2004), and Lerner (2006).

  6. 6.

    Gorton (2009, 2010) strongly disagrees with the “originate-to-distribute” explanation of the crisis, which places the blame on the misaligned incentives of the underwriters, who believed they had little exposure to risk, on the rating agencies, which did not properly represent risk to investors, and on a decline in lending standards which allowed increasingly poor loans to be made. Here Gorton becomes much less convincing, especially in light of later information, and he argues as if proponents of the originate-to-distribute explanation are directly attacking the general process of securitization itself. But there is little in Gorton’s account to suggest that the originate-to-distribute explanation is excluded by the asymmetric information hypothesis. Simply because many lenders went under after the fact does not mean that their incentives were necessarily aligned correctly beforehand. However, there is some anecdotal evidence to suggest that a number of the most troubled financial institutions ran into difficulties in 2007–2008 precisely because they did not distribute all of the securitized debt they created, but kept a significant portion on their own balance sheets instead (Lo 2012, 10).

  7. 7.

    The term “subprime” refers to the credit quality of the mortgage borrower as determined by various consumer credit rating bureaus. The highest-quality borrowers are referred to as “prime”; hence the term “prime rate” refers to the interest rate charged on loans to such low-default-risk individuals. Accordingly, “subprime” borrowers have lower credit scores and are more likely to default than prime borrowers.

  8. 8.

    Haavio et al. (2013) empirically study the linkages between financial variable downturns and economic recessions and present evidence that real asset prices tend to lead real cycles. They document that downturns in real asset prices, particularly real house prices, are useful leading indicators of economic recessions.

  9. 9.

    Gorton actually uses analogy of E. coli—tainted beef in millions of pounds of perfectly good hamburger.

  10. 10.

    “Mark-to-market pricing” is the practice of updating the value of a financial asset to reflect the most recent market transaction price. For illiquid assets that do not trade actively, marking such assets to market can be quite challenging, particularly if the only transactions that have occurred are fire sales in which certain investors are desperate to rid themselves of such assets and sell them at substantial losses. This has the effect of causing all others who hold similar assets to recognize similar losses when they are forced to mark such assets to market, even if they have no intention of selling these assets (Lo 2012, 10).

  11. 11.

    Bebchuk and Spamann (2010) and Bhagat and Bolton (2013) seek to make some contributions to understand how banks’ executive pay has produced incentives for excessive risk taking and how such pay should be reformed. In the case of Bear Stearns and Lehman Brothers, Bebchuk et al. (2009) argued that their CEOs cashed out hundreds of millions of dollars of company stock from 2000 to 2008; hence the remaining amount of equity they owned in their respective companies toward the end may not have been sufficiently large to have had an impact on their behavior. Nevertheless, in an extensive empirical study of major banks and broker–dealers before, during, and after the financial crisis, Murphy (2012) concludes that the Wall Street culture of low base salaries and outsized bonuses of cash, stock, and options actually reduces risk-taking incentives, not unlike the so-called fulcrum fee in which portfolio managers have to pay back a portion of their fees if they underperform (Lo 2012, 2). Finally, in a recent paper Edmans and Gabaix (2015) study traditional and modern theories of executive compensation, bringing them together under a unifying framework. They analyze assignment models of the level of pay, and static and dynamic moral hazard models of incentives, and compare their predictions to empirical findings.

  12. 12.

    Farmer et al. (2012) demonstrate that financial markets, by their nature, cannot be Pareto efficient, except by chance. Although individuals are rational, they show that it is sufficient to assume heterogeneity in agent’s subjective discount factor to conclude that markets are not Pareto efficient.

  13. 13.

    For decades credit rating agencies were viewed as trusted arbiters of creditworthiness and their ratings as important tools for managing risk. The common narrative is that the value of ratings was compromised by the evolution of the industry to a form where issuers pay for ratings. Cole and Cooley (2014) show how credit ratings have value in equilibrium and how reputation insures that, in equilibrium, ratings will reflect sound assessments of credit worthiness. There will always be an information distortion because of the fact that purchasers of ratings need not reveal them. Cole and Cooley argue that regulatory reliance on ratings and the increasing importance of risk-weighted capital in prudential regulation have more likely contributed to distorted ratings than the matter of who pays for them. In this respect, they conclude that much of the regulatory obsession with the conflict created by issuers paying for ratings is a distraction.

  14. 14.

    Financial crises are often associated with significant movements in exchange rates, which reflect both increasing risk aversion and changes in the perceived risk of investing in certain currencies. Kohler (2010) explains why exchange rate movements during the global financial crisis of 2007–2009 were unusual. Unlike in two previous episodes—the Asian crisis of 1997–1998 and the crisis following the Russian debt default in 1998—in 2008 many countries that were not at the center of the crisis saw their currencies depreciate sharply. Such crisis-related movements reversed strongly for a number of countries. Two factors are likely to have contributed to these developments. First, during the latest crisis, safe haven effects went against the typical pattern of crisis-related flows. Second, interest rate differentials explain more of the crisis-related exchange rate movements in 2008–2009 than in the past. This probably reflects structural changes in the determinants of exchange rate dynamics such as the increased role of carry trade activity.

  15. 15.

    What happened in the USA during the 2007–2009 financial crisis is summerized by Carlson et al. (2015) as follows. There were severe reductions in the liquidity of financial markets, runs on the shadow banking system, and destabilizing defaults and near-defaults of major financial institutions. In response, the Federal Reserve, in its role as lender of last resort (LOLR), injected extraordinary amounts of liquidity. In the aftermath, lawmakers and regulators have taken steps to reduce the likelihood that such lending would be required in the future, including the introduction of liquidity regulations. These changes were motivated in part by the argument that central bank lending entails extremely high costs and should be made unnecessary by liquidity regulations. By contrast, some have argued that the loss of liquidity was the result of market failures, and that central banks could solve such failures by lending, making liquidity regulations unnecessary. They argue that LOLR lending and liquidity regulations are complementary tools. Liquidity shortfalls can arise for two very different reasons: first, sound institutions can face runs or a deterioration in the liquidity of markets they depend on for funding; second, solvency concerns can cause creditors to pull away from troubled institutions. Central bank lending is the best response in the former situation, while orderly resolution (by the institution as it gets through the problem on its own or via a controlled failure) is the best response in the second one.

  16. 16.

    “Quantitative easing” is defined as a policy strategy by a Central Bank of seeking to reduce long-term interest rates by buying large quantities of financial assets when the overnight rate is near zero (Bullard 2010).

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  1. Department of Economics and Business, University of Cagliari, Viale San Ignazio 17, 09123, Cagliari, Italy

    Beniamino Moro

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Moro, B. (2016). The Run on Repo and the Policy Interventions to Struggle the Great Crisis. In: Modern Financial Crises. Financial and Monetary Policy Studies, vol 42. Springer, Cham. https://doi.org/10.1007/978-3-319-20991-3_4

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