lucas on '08 repo run

"The repo market

As deposits moved out of commercial banks, investment banks and money market funds increasingly provided close substitutes for the services commercial banks provide. Like the banks they replaced, they accepted cash in return for promises to repay with interest, leaving the option of when and how much to withdraw up to the lender. The exact form of the contracts involved came in enormous variety. In order to support these activities, financial institutions created new securities and new arrangements for trading them, arrangements that enabled them collectively to clear ever larger trading volumes with smaller and smaller holdings of actual cash. In August of 2008, the entire banking system held about $50 billion in actual cash reserves while clearing trades of $2,996 trillion per day.² Yet every one of these trades involved an uncontingent promise to pay someone hard cash whenever he asked for it. If ever a system was “runnable,” this was it. Where did the run occur?

...There were two runs on investment banks... The run on Bear Stearns in March ended with its purchase by JPMorgan Chase, and the run on Lehman Brothers in September ended with its bankruptcy. In addition, there was an incipient run on money market mutual funds following the collapse of Lehman, halted only when the Treasury stepped in to provide deposit insurance for those institutions.

Of course,... these events also heightened the fear of contagion for all financial institutions, altering their willingness to engage in various transactions. "

"In economic terms a repurchase agreement (repo) is a securitized loan.³ The lender brings cash to the transaction, while the borrower supplies a T-bill or some other security to be used as collateral. The loans are short term, often one day.

Large lenders in the repo market include money market mutual funds and hedge funds. The repo market performs for these large institutions the same function that commercial banks perform for smaller depositors. In effect, it allows them to pool their cash, collectively economizing on their stocks of non-interest-bearing assets. For lenders, the repo market is attractive because the loans are very short term, so it is a way to earn a return—albeit modest—on cash reserves that would otherwise be idle. In normal times, any lender can withdraw cash by declining to roll over earlier loans. Firms that do not want liquidity do not lend in the repo market, since higher returns are available elsewhere."

" Consider a shock that heightens uncertainty about the soundness of financial institutions. Potential lenders will choose to hold more of their cash in reserve, anticipating possible withdrawals by their own clients. As a result, potential borrowers will find it difficult to obtain funds. Actual defaults are rare in this market, but borrowers who hoped to roll over old agreements may have to sell securities on short notice, perhaps at fire sale prices, to obtain cash elsewhere."

The Repo Market and other Monetary Aggregates January 2008 to January 2009
	Jan. 2008 (billions)	Jan. 2009 (billions)	Change
Cash Held Outside of Banks*	$773.9	$832.2	+7.5%
Private, Domestic Demand Deposits*	$510.7	$658.0	+28.8%
Money Market Mutual Funds*	$3,033.1	$3,757.3	+23.9%
Repos held by Primary Dealers** Total Overnight & Continuing	$3,699.4 $2,543.6	$2,585.9 $2,005.6	-30.1% -21.2%

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 At the beginning of 2008, primary dealers held total funds of $3.70 trillion in the repo market, of which $2.54 trillion was in overnight or continuing agreements. Those figures grew slightly during the first half of 2008. Total funds then fell to $2.59 trillion at the beginning of 2009, a 30 percent decline, while overnight and continuing agreements fell to $2.01 trillion, a 21 percent decline. Both figures showed further declines over the subsequent year as well.

Lessons from the panic of 2008

We began by asking what theory and evidence tell us about liquidity crises and about policies to avoid them or to mitigate their severity. The arguments above do not provide a complete answer, but they do point to some broad principles.

(a) Bank regulation can reduce the likelihood of liquidity crises, but it cannot eliminate them entirely.
Banks will fail, and these failures will make failure more likely for others. There is language in Dodd-Frank suggesting that the Fed should take responsibility for predicting and precluding crises, but this task seems to us to be an impossible one, at least for the foreseeable future.⁴

(b) During a liquidity crisis, the Fed should act as a lender of last resort.

In the event of a bank run or a run on the repo market, the Fed can always add liquidity to the system, and there will be occasions—as in 1930 and in the fall of 2008—when it would be irresponsible not to do so.

(c) The Fed should announce its policy for liquidity crises, explaining how and under what circumstances it will come into play.

The events of 2008 illustrate the importance of an announced and well-understood policy. Over the years prior to 2008, investors came to understand that the Fed was operating under an implicit too-big-to-fail policy, in the sense that the depositors/creditors of large banks would be protected. No other policy was ever discussed, and the Fed’s assistance in engineering the orderly exit of Bear Stearns in March 2008 was surely interpreted as evidence that this policy was still in place. The abrupt end of Lehman in September was then all the more shocking.
There is no gain from allowing uncertainty about how the Fed will behave. The beliefs of depositors/lenders are critical in determining the contagion effects of runs that do occur. By announcing a credible policy, the Fed can affect those beliefs, and the Fed needs to use this tool.

(d) Deposit insurance is part of the answer.

When introduced in the Banking Act of 1933, deposit insurance was limited to small deposits, and its role was viewed as consumer protection, not run prevention. Deposit insurance performed this function well during the 2008 crisis: There were no runs on FDIC-insured commercial banks, although many failed or were absorbed by stronger institutions.

Deposit insurance should be retained, although for the reasons described by Kareken and Wallace, the assets held against insured deposits should be carefully regulated.

(e) Deposit insurance has a limited role.

Investment banks, money market funds and the repo market are outside the protection of the insured system, and the liquidity crisis of 2008 involved these other institutions. Could they be brought into the fold, with the relevant portion of their investment portfolio regulated in the same way that commercial banks are?

Higher returns in the uninsured sector will always be attractive for large depositors, and new institutions or arrangements would surely arise, offering liquidity provision on the old, risky terms. Clients will want it, markets will have a strong incentive to provide it and regulators will probably not be able to contain their efforts. Providers will be able to innovate around regulations or move offshore to avoid them. This dilemma leads us to our next point.

(f) The Fed’s lending in a crisis should be targeted toward preserving market liquidity, not particular institutions.

There are two goals here: to have a credible policy for how liquidity will be injected in a crisis and to provide proper incentives for banks during ordinary times. Both goals are met by the Bagehot rule: In a crisis, the central bank should lend on good collateral at a penalty rate. To implement this rule, we need to know how much the Fed should lend and what assets will be regarded as good collateral.

Time consistency requires that no upper bound be placed on crisis lending. The guidelines we have for monetary policy, whether stated in terms of monetary aggregates or interest rates, are directed at long-term objectives and are no help in a liquidity crisis. After the Lehman failure in the fall of 2008, the Fed expanded bank reserves from $40 billion to $800 billion in three months, surely exceeding by far any limit that would have been imposed in August. Even with this decisive response, spending declined sharply over next two quarters.

Because crises occur too rarely for the ex ante formulation of useful quantitative rules, the Fed should have considerable discretion in times of crisis. Nevertheless, because policies should be predictable, the Fed should describe the indicators it will use to decide when lending has reached a sufficient level.

Defining good collateral is more complicated. The quality of collateral is in the eye of the lender, and it can change dramatically from week to week. In this application, though, the lender is the Fed, and it is the responsibility of the Fed to define what it will treat as good collateral. To this end, the Fed should announce an ordering of assets by their quality. The list should be long enough to cover all contingencies, and it would need to be revised from time to time.

In such a regime, banks outside the FDIC would be free to choose their portfolios, with clients, bondholders and equity holders bearing the risk that those choices entail. The lower return on lower-risk assets would be offset, at least in part, by their superior status as collateral in the event of a crisis.

Avoiding liquidity crises altogether is probably more than we can hope for. What we can do is put in place mechanisms to make such crises infrequent and to make their effects manageable