In a new paper published by NBER, Gary Gorton, Toomas Laarits, and Andrew Metrick use a novel data set to determine the role of the “repo” market (where lenders make short-term loans in exchange for collateral) as a propagation mechanism in the financial crisis.
The Financial Crisis began and accelerated in short-term money markets. One such market is the multi-trillion dollar sale-and-repurchase (“repo”) market, where prices show strong reactions during the crisis. The academic literature and policy community remain unsettled about the role of repo runs, because detailed data on repo quantities is not available. We provide quantity evidence of the run on repo through an examination of the collateral brought to emergency liquidity facilities of the Federal Reserve. We show that the magnitude of repo discounts (“haircuts”) on specific collateral is related to the likelihood of that collateral being brought to Fed facilities.
Before the financial crisis, the multi-trillion-dollar repo market was lightly regulated (non-bank institutions in this market are sometimes called “shadow banks”) and funded almost half of the asset holdings of major investment banks.
In the repo market, the difference between the value of the loan and the value of the collateral posted is called the “haircut.” For example, if I post a $100 value bond for a $90 loan, the haircut is 10%.
How does this relate to the financial crisis? Previous research found that an increase in haircuts is associated with a “run” on repo–when haircuts increase, borrowers get less cash for the same amount of collateral, forcing banks to make up the difference. To do this, they can “sell the bond rather than fund it in the repo market (i.e. in a fire sale) [or use] the bond as collateral (if it is eligible) and borrow from an emergency lending facility and repay the repo lender.”
The authors complement this previous research by using the quantity (rather than price) evidence in their paper. By using data from various emergency-lending programs that allowed emergency borrowing outside the Federal Reserve’s discount window, they provide evidence based on the quantity of lending that increased haircut size is a strong predictor of emergency lending, and thus a mechanism by which the financial crisis spread.