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The Run On Repo and the Liquidity Shortage Problems of the Current Global Financial Crisis: Europe vs. The US

Year 2013, Volume: 2 Issue: 1, 41 - 77, 01.01.2013

Abstract

This paper discusses several key issues regarding the current Great Crisis, which has extended over two periods. The first period covered the 2007-09 subprime crisis in the US, while the second took the form of a twin sovereign debt and banking crisis in Europe after 2010, and persists until now. At the core of the problem is the emergence over the last 30 years of a shadow banking system, which re-created the conditions for a panic. This time, the panic firstly took place in the repo market, which suffered a run when “depositors” demanded ever-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 more frequent haircuts, the US banking system was effectively insolvent for the first time since the Great Depression. Via the banking system, the American “run on repo” soon infected the European financial system, becoming both a twin sovereign debt and banking debacle in many peripheral Euro area countries that raised doubts of the survival of the Euro and the regular functioning of the European Monetary System. The paper concludes that, for a successful European crisis resolution, we need to implement both a fiscal union and a banking union, ensuring that fiscal and banking policies in the Eurozone are partly centralized so as to meet the requirements necessary for the regular functioning of a monetary union.

Thanks

wish to thank Riccardo De Lisa, Paolo Mattana, Vincenzo Merella, Alessio Moro, and Romano Piras and two anonymous referees for their comments, which helped me greatly. The usual disclaimers apply.

References

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  • Bakk-Simon, K., S. Borgioli, C. Giron, H. S. Hempell, A. Maddaloni, F. Recine, and S. Rosati, (2011), “Shadow Banking in the Euro Area: An Overview,” ECB Occasional Paper No. 133, September.
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  • Bebchuk, L., A. Cohen and H. Spamann, (2010), “The Wages of Failure: Executive Compensation at Bear Stearns and Lehman, 2000-2008,” Discussion Paper No. 657, John M. Olin Center for Law, Economics, and Business, Harvard Law School.
  • Bergsten, F. and J. F. Kirkegaard, (2012), “The Coming Resolution of the European Crisis,” in Peterson Institute for International Economics, Policy Brief, January (http://www.iie.com/publications/pb/pb12-1.pdf).
  • Bernanke, B. S., (2004), The Great Moderation, Remarks at the meetings of the Eastern Economic Association, Washington, DC, February 20 (http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2004/20040220/default.htm).
  • Bhagat, S. and B. Bolton, (2011), “Bank Executive Compensation and Capital Requirements Reform,” draft, January.
  • Blommestein, H. J., (2012), “The Debate over Sovereign Risk, Safe Assets, and the Risk-Free Rate: What are the Implications for Sovereign Issuers?” Ekonomi-tek, Vol. 1, No. 3, pp. 55-70.
  • Brunnermeier, M. K., (2009), “Deciphering the Liquidity and Credit Crunch 2007-2008,” Journal of Economic Perspectives, Vol. 23, No. 1, pp. 77-100.
  • Brunnermeier, M. K., G. Gorton, and A. Krishnamurthy, (2011), “Risk Topography,” draft, May 31 (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1825124).
  • Brunnermeier, M. K. and M. Oehmke, (2012), “Bubbles, Financial Crisis, and Systemic Risk,” in Handbook of the Economics of Finance, G. M. Constantinides, M. Harris, and R. M. Stulz (Eds.), Amsterdam, North Holland, Vol. 2, pp. 1221-1288.
  • Buiter, W. H. and A. Siebert, (2005), “How the Eurosystem’s Treatment of Collateral in its Open Market Operations Weakens Fiscal Discipline in the Eurozone (And What To Do About It),” CEPR Discussion Paper No. 5387, London.
  • Bullard, J., (2010), “Quantitative Easing: Uncharted Waters for Monetary Policy,” The Regional Economist, Vol. 18, No. 1.
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  • Claessens, S. and M. A. Kose, (2013), “Financial Crises: Explanations, Types, and Implications,” CEPR Discussion Paper No. DP9329, February.
  • Dang, T. V., G. Gorton, and B. Holmström, (2009), “Opacity and the Optimality of Debt for Liquidity Provision,” draft, November 30.
  • Das, U., Y. Lu, M. G. Papaioannou, and I. K. Petrova, (2012), “Sovereign Risk and Asset and Liability Management—Conceptual Issues,” IMF Working Paper No. 12/241, October.
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  • Forbes, K., (2012), “The ‘Big C’: Identifying Contagion,” NBER Working Paper No. 18465, October.
  • Fraher, J. and S. Kennedy, (2008), “Central Banks Offer Extra Funds to Calm Money Markets,” Bloomberg.com, September 18. http://www.bloomberg.com/apps/news?pid=20601087&refer=home&sid=ahBSRLQsJFzI#
  • Fratianni, M., (2008), “Financial Crises, Safety Nets, and Regulation,” Rivista Italiana degli Economisti, Vol. XIII, No. 2.
  • Goldstein, I. and A., Razin, (2013), “Review of Theories of Financial Crises,” NBER Working Paper No. w18670, January.
  • Gorton, G., (2008), “The Panic of 2007,” in Maintaining Stability in a Changing Financial System, Proceedings of the 2008 Jackson Hole Conference, Federal Reserve Bank of Kansas City.
  • Gorton, G., (2009), Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007, Prepared for the Federal Reserve Bank of Atlanta’s 2009 Financial Markets Conference: Financial Innovation and Crisis, May 11-13. (http://www.frbatlanta.org/news/CONFEREN/09fmc/gorton.pdf).
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  • Gorton, G. and A. Metrick, (2009a), “Haircuts,” NBER Working Paper No. 15273, August.
  • Gorton, G. and A. Metrick, (2009b), “The Run on Repo and the Panic of 2007-2008,” Yale Working Paper.
  • Gorton, G. and A. Metrick, (2010), “Securitized Banking and the Run on Repo,” Yale ICF Working Paper No. 09-14, November.
  • Gorton, G. and A. Metrick, (2012a), “Getting up to Speed on the Financial Crisis: A One-Weekend Reader’s Guide,” NBER Working Paper No. 17778, January. (http://www.nber.org/papers/w17778.pdf?new_window=1).
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  • Gorton, G. and G. L. Ordonez, (2012), “Collateral Crises,” NBER Working Paper No. 17771, January.
  • Gorton, G. and G. Pennacchi, (1990), "Financial Intermediaries and Liquidity Creation, Journal of Finance, Vol. 45, March, pp. 49-72.
  • Gorton, G. and G. Pennacchi, (1993), "Security Baskets and Index-Linked Securities," Journal of Business, Vol. 66, No. 1, pp. 1-29.
  • Gorton, G. and N. S. Souleles, (2006), “Special-Purpose Vehicles and Securitization,” in The Risks of Financial Institutions, R. Stulz and M. Carey (Eds.), University of Chicago Press, 2006.
  • Greenspan, A., (2010), The Crisis, Second Draft, March 9. (http://www.brookings.edu/~/media/Files/Programs/ES/BPEA/2010 spring_bpea_papers/spring2010_greenspan.pdf).
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  • Kohler, M., (2010), “Exchange Rates During Financial Crises,” BIS Quarterly Review, March.
  • Krugman, P., (2009), The Return of Depression Economics and the Crisis of 2008, NY, Norton.
  • Lerner, J., (2006), “The New Financial Thing: The Origins of Financial Innovations,” in Journal of Financial Economics, Vol. 79, pp. 223-255.
  • Lo, A. W., (2012), “Reading About the Financial Crisis: A 21-Book Review,” draft, January 9. (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1949908)
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The Run On Repo and the Liquidity Shortage Problems of the Current Global Financial Crisis: Europe vs. The US

Year 2013, Volume: 2 Issue: 1, 41 - 77, 01.01.2013

Abstract

This paper discusses several key issues regarding the current Great Crisis, which has extended over two periods. The first period covered the 2007-09 subprime crisis in the US, while the second took the form of a twin sovereign debt and banking crisis in Europe after 2010, and persists until now. At the core of the problem is the emergence over the last 30 years of a shadow banking system, which re-created the conditions for a panic. This time, the panic firstly took place in the repo market, which suffered a run when “depositors” demanded ever-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 more frequent haircuts, the US banking system was effectively insolvent for the first time since the Great Depression. Via the banking system, the American “run on repo” soon infected the European financial system, becoming both a twin sovereign debt and banking debacle in many peripheral Euro area countries that raised doubts of the survival of the Euro and the regular functioning of the European Monetary System. The paper concludes that, for a successful European crisis resolution, we need to implement both a fiscal union and a banking union, ensuring that fiscal and banking policies in the Eurozone are partly centralized so as to meet the requirements necessary for the regular functioning of a monetary union.

References

  • Altman, R. C., (2009), The Great Crash, 2008, The Brookings Institution. (http://www.jmhinternational.com/news/news/selectednews/files/2009/0 1/20090201_20090101_Foreign%20Affairs_TheGreatCrash2008.pdf).
  • Bakk-Simon, K., S. Borgioli, C. Giron, H. S. Hempell, A. Maddaloni, F. Recine, and S. Rosati, (2011), “Shadow Banking in the Euro Area: An Overview,” ECB Occasional Paper No. 133, September.
  • Bank for International Settlements, (2001), “Collateral in Wholesale Financial Markets: Recent Trends, Risk Management, and Market Dynamics,” Bank for International Settlements, Committee on the Global Financial System, March.
  • Bartoletto, S., B. Chiarini and E. Marzano, (2012), “The Sustainability of Fiscal Policy in Italy: A Long-Term Perspective,” CESifo Working Paper Series No. 3812, May 15.
  • Bebchuk, L. and H. Spamann, (2009), “Regulating Bankers’ Pay,” Harvard Law School, Discussion Paper No. 641, also in Georgetown Law Journal (2010).
  • Bebchuk, L., A. Cohen and H. Spamann, (2010), “The Wages of Failure: Executive Compensation at Bear Stearns and Lehman, 2000-2008,” Discussion Paper No. 657, John M. Olin Center for Law, Economics, and Business, Harvard Law School.
  • Bergsten, F. and J. F. Kirkegaard, (2012), “The Coming Resolution of the European Crisis,” in Peterson Institute for International Economics, Policy Brief, January (http://www.iie.com/publications/pb/pb12-1.pdf).
  • Bernanke, B. S., (2004), The Great Moderation, Remarks at the meetings of the Eastern Economic Association, Washington, DC, February 20 (http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2004/20040220/default.htm).
  • Bhagat, S. and B. Bolton, (2011), “Bank Executive Compensation and Capital Requirements Reform,” draft, January.
  • Blommestein, H. J., (2012), “The Debate over Sovereign Risk, Safe Assets, and the Risk-Free Rate: What are the Implications for Sovereign Issuers?” Ekonomi-tek, Vol. 1, No. 3, pp. 55-70.
  • Brunnermeier, M. K., (2009), “Deciphering the Liquidity and Credit Crunch 2007-2008,” Journal of Economic Perspectives, Vol. 23, No. 1, pp. 77-100.
  • Brunnermeier, M. K., G. Gorton, and A. Krishnamurthy, (2011), “Risk Topography,” draft, May 31 (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1825124).
  • Brunnermeier, M. K. and M. Oehmke, (2012), “Bubbles, Financial Crisis, and Systemic Risk,” in Handbook of the Economics of Finance, G. M. Constantinides, M. Harris, and R. M. Stulz (Eds.), Amsterdam, North Holland, Vol. 2, pp. 1221-1288.
  • Buiter, W. H. and A. Siebert, (2005), “How the Eurosystem’s Treatment of Collateral in its Open Market Operations Weakens Fiscal Discipline in the Eurozone (And What To Do About It),” CEPR Discussion Paper No. 5387, London.
  • Bullard, J., (2010), “Quantitative Easing: Uncharted Waters for Monetary Policy,” The Regional Economist, Vol. 18, No. 1.
  • Candelon, B. and F. C. Palm, (2010), “Banking and Debt Crises in Europe: The Dangerous Liaisons?” CESIFO Working Paper No. 3001, March.
  • Carpinelli, L., (2009), “Effetti Reali Delle Crisi Bancarie: Una Rassegna Della Letteratura,” in Banca d’Italia, Questioni di Economia e Finanza, Occasional Paper 55, September.
  • Claessens, S. and M. A. Kose, (2013), “Financial Crises: Explanations, Types, and Implications,” CEPR Discussion Paper No. DP9329, February.
  • Dang, T. V., G. Gorton, and B. Holmström, (2009), “Opacity and the Optimality of Debt for Liquidity Provision,” draft, November 30.
  • Das, U., Y. Lu, M. G. Papaioannou, and I. K. Petrova, (2012), “Sovereign Risk and Asset and Liability Management—Conceptual Issues,” IMF Working Paper No. 12/241, October.
  • De Grauwe, P., (2010), “Crisis in the Eurozone and How to Deal With it,” CEPS Policy Brief No. 204.
  • Driffill, J., (2013), “Financial Shocks, Unemployment, and Public Policy,” CEPR Discussion Paper No. DP9321, January.
  • Fahlenbrach, R. and R. M. Stulz, (2011), “Bank CEO Incentives and the Credit Crisis,” in Journal of Financial Economics, Vol. 99, pp. 11-26.
  • Farmer, R. E. A., C. Nourry, and A. Venditti, (2012), “The Inefficient Market Hypothesis: Why Financial Markets Do Not Work Well in the Real World,” NBER Working Paper No. 18647, December.
  • Forbes, K., (2012), “The ‘Big C’: Identifying Contagion,” NBER Working Paper No. 18465, October.
  • Fraher, J. and S. Kennedy, (2008), “Central Banks Offer Extra Funds to Calm Money Markets,” Bloomberg.com, September 18. http://www.bloomberg.com/apps/news?pid=20601087&refer=home&sid=ahBSRLQsJFzI#
  • Fratianni, M., (2008), “Financial Crises, Safety Nets, and Regulation,” Rivista Italiana degli Economisti, Vol. XIII, No. 2.
  • Goldstein, I. and A., Razin, (2013), “Review of Theories of Financial Crises,” NBER Working Paper No. w18670, January.
  • Gorton, G., (2008), “The Panic of 2007,” in Maintaining Stability in a Changing Financial System, Proceedings of the 2008 Jackson Hole Conference, Federal Reserve Bank of Kansas City.
  • Gorton, G., (2009), Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007, Prepared for the Federal Reserve Bank of Atlanta’s 2009 Financial Markets Conference: Financial Innovation and Crisis, May 11-13. (http://www.frbatlanta.org/news/CONFEREN/09fmc/gorton.pdf).
  • Gorton, G., (2010), Slapped by the Invisible Hand: The Panic of 2007, Oxford University Press.
  • Gorton, G. and A. Metrick, (2009a), “Haircuts,” NBER Working Paper No. 15273, August.
  • Gorton, G. and A. Metrick, (2009b), “The Run on Repo and the Panic of 2007-2008,” Yale Working Paper.
  • Gorton, G. and A. Metrick, (2010), “Securitized Banking and the Run on Repo,” Yale ICF Working Paper No. 09-14, November.
  • Gorton, G. and A. Metrick, (2012a), “Getting up to Speed on the Financial Crisis: A One-Weekend Reader’s Guide,” NBER Working Paper No. 17778, January. (http://www.nber.org/papers/w17778.pdf?new_window=1).
  • Gorton, G. and A. Metrick, (2012b), “Securitization,” NBER Working Paper No. W18611.
  • Gorton G. and A. Metrick, (2012c), “Who Ran on Repo?”, NBER Working Paper No. w18455, October.
  • Gorton, G. and G. L. Ordonez, (2012), “Collateral Crises,” NBER Working Paper No. 17771, January.
  • Gorton, G. and G. Pennacchi, (1990), "Financial Intermediaries and Liquidity Creation, Journal of Finance, Vol. 45, March, pp. 49-72.
  • Gorton, G. and G. Pennacchi, (1993), "Security Baskets and Index-Linked Securities," Journal of Business, Vol. 66, No. 1, pp. 1-29.
  • Gorton, G. and N. S. Souleles, (2006), “Special-Purpose Vehicles and Securitization,” in The Risks of Financial Institutions, R. Stulz and M. Carey (Eds.), University of Chicago Press, 2006.
  • Greenspan, A., (2010), The Crisis, Second Draft, March 9. (http://www.brookings.edu/~/media/Files/Programs/ES/BPEA/2010 spring_bpea_papers/spring2010_greenspan.pdf).
  • Holmström, B., (2008), "Discussion of ‘The Panic of 2007,’ by Gary Gorton,” in Maintaining Stability in a Changing Financial System, Proceedings of the 2008 Jackson Hole Conference, Federal Reserve Bank of Kansas City, 2008.
  • Hull, J. C., (2009), “The Credit Crunch of 2007: What Went Wrong? Why? What Lessons Can Be Learned?” Journal of Credit Risk, Vol. 5, No. 2, pp. 3-18. Kaminsky, G. L. and C. M. Reinhart, (1999), “The Twin Crises: The Causes of Banking and Balance-of-Payments Problems,” American Economic Review, Vol. 89, No 3, pp. 473-500.
  • Kindleberger, C. P., (1978), Manias, Panics, and Crashes: A History of Financial Crises, New York, Wiley (5th edition, 2005).
  • Kirkegaard, J. F., (2012), “Brinkmanship in Brussels, Sturm and Drachma for Greece and Europe,” Vox, March 1.
  • Knight, M. D., (2008), Some Reflections on the Future of the Originate-to- Distribute Model in the Context of the Current Financial Turmoil, Speech at the Euro 50 Group Roundtable, London, 21 April. (http://www.bis.org/speeches/sp080423.htm)
  • Kohler, M., (2010), “Exchange Rates During Financial Crises,” BIS Quarterly Review, March.
  • Krugman, P., (2009), The Return of Depression Economics and the Crisis of 2008, NY, Norton.
  • Lerner, J., (2006), “The New Financial Thing: The Origins of Financial Innovations,” in Journal of Financial Economics, Vol. 79, pp. 223-255.
  • Lo, A. W., (2012), “Reading About the Financial Crisis: A 21-Book Review,” draft, January 9. (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1949908)
  • Mayer, T., (2011), “Euroland’s Hidden Balance-of-Payments Crisis,” EU Monitor, 88, October 26.
  • (http://www.dbresearch.com/PROD/DBR_INTERNET_EN-PROD/PROD0000000000279906/Euroland%E2%80%99s+hidden+balanceof-payments+crisis.pdf)
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There are 80 citations in total.

Details

Primary Language English
Subjects Economics
Journal Section Research Articles
Authors

Beniamino Moro This is me

Publication Date January 1, 2013
Published in Issue Year 2013 Volume: 2 Issue: 1

Cite

APA Moro, B. (2013). The Run On Repo and the Liquidity Shortage Problems of the Current Global Financial Crisis: Europe vs. The US. Ekonomi-Tek, 2(1), 41-77.