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1/ On how repurchase agreements can cause liquidity to dry up
1/ On how repurchase agreements can cause liquidity to dry up
2/ Note: I use a very loose definition of “repurchase agreements” that includes the derivatives collateral that is exchangeable for repo collateral under Master Agreemts. Since the financial crisis the shift towards repo & away from traditional interbank markets has bn pronounced
3/ Key points: (i) repo is a very specialized collateral contract. It deliberately favors lenders to the greatest degree possible. But maximizing the safety of lenders also maximizes the risk to borrowers. (Contrast w mortgages where lender is at risk of borrower "walking away".)
4/ (ii) This then explains the safe asset shortage – or more precisely the dramatic increase in the demand for safe assets. Repo borrowers who post risky assets as collateral are at risk of dramatic losses in a liquidity crisis. --> Repo borrowers prefer safe assets.
5/ Effectively the shift from traditional interbank markets to repo-based markets necessarily segments assets into “flight to safety” assets that are protected in a liquidity crisis and all other assets. This explains why long-term T bonds w sig’t price risk are consider “safe”.
6/ (iii) This structural increase in demand for safe assets then explains the increase in the cost (measured in spreads) of financing business activity & secular stagnation. This shift in financial markets is causing the economy to lose capacity to finance entrepreneurship.
7/ Another way of looking at this is through the lens of liquidity.
8/ As Keynes explained liquidity exists only for agents at the microeconomic level, “there is no such thing as liquidity of investment for the community as a whole” i.e. at the macroeconomic level.
9/ By contrast, repos are premised on the neoclassical model where markets are a fundamental source of liquidity. i.e. repos assume that the presence of markets will protect lenders. This, ofc, ignores Keynes pt: repos can be “safe” only from a micro, not from a macro perspective
10/ Whn repos are treated as safe assets at the macro level, they mostly serve to expose the flaws in the neoclassical theory that imagines markets as liquid. “Liquidity” is what the neoclassical model gets dead wrong. Repos hv the counterperformative effect of demo’ing this.
11/ Thus, liquidity crises like those experienced in 2008 are the consequence of taking the neoclassical model too seriously. They had the ultimate effect of promoting an alternative theory that governments, not markets, are the fundamental source of liquidity.
12/ I argue that liquidity is more complicated than “governments” or “markets.” That liquidity arises instead from the structured interaction of banks, governments (or central banks) and markets.
13/ Thus, markets are liquid *because* they are supported by banks which have the capacity – with the assistance of the central bank – to “hide” illiquid assets on their balance sheets through a crisis and thus to smooth over market liquidity events.
14/ I argue that the modern repo-based system deliberately circumvents this bank-based source of liquidity and thus has the effect of exposing the liquidity crises that are always latent in markets. As a result this modern repo-based system makes liquidity crises endemic.
15/ A limited number of ungated copies are available here: tandfonline.com/eprint/UJR6P2V…
