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

Beniamino Moro

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.

Keywords

Financial crisis, shadow banking system, panic, sovereign debt crisis, banking crisis

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.

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