claimed by famous British Historian Ferguson (2012) in his speech, financial
markets have been deregulated for more than two decades: “
Deregulation in the two decades after the election of Ronald
Reagan led to the “disappearance” of thrift from American society and to
excessive risk-taking by banks. Deregulation had no macroeconomic benefits; in
fact, productivity declined” (Ferguson, 2012, p. 1).
As a result of this deregulation, favourable circumstances emerged
for the new financial instruments. Gorton and Metrick (2009) stated that the
Panic of 2007-2008 was a run on the sale and repurchase market (the “repo”
market). The repo market is a very large, short-term market that provides
financing for a wide range of securitization activities and financial
This paper will discuss the main problems affecting
money markets in 2007-08.
first part of this essay will offer a brief explanation of
the nature of the financial instruments and markets whilst
how a bank run
. Finally, this article will
conclude with a summary of how the phenomenon affected the money markets.
Instruments and Markets
Money markets are a segment of the
financial market in which financial instruments with high liquidity and very
short maturities are traded, usually for less than one year. Money markets
bring together borrowers and investors without intermediation by banks. The
recent problems affecting money markets in 2007-08 took place in the
securitized-banking” system, when banks were willing to lend to each other:
“The Global Credit Crisis first erupted in summer 2007; in particular, on
August 9, 2007, the short-term funding market and interbank lending all but
(Shin, 2009, p. 102).
It is worth initially referring to
LIBOR (the London Interbank Offered Rate), which is used as a base rate for
many financial transactions; in particular, the three-month LIBOR rate which is
considered very safe. Based on Arnold’s (2011) research, the official LIBOR
rates are calculated by the British Banking Association (BBA) as a panel of 16
UK and international banks are asked at what rates they could borrow money as
unsecured loans of various maturities. The loans between banks are made not
just in sterling, but in a variety of currencies, and take place in London, one
of the leading international financial centres of the world. It is illustrated
below how the LIBOR rate was changing; during the Financial Crisis it reached a
peak of approximately 6.5% in January 2008, whilst in January 2010, the rate
was approximately 0.5%. This example is helpful, as it provides a clear sign
that confidence had returned to the banking system and that institutions were
willing to lend to each other, thus making the economy more stable after 2007
LIBOR and Central Bank
rates (Source: lecture money market)
Additionally, the most influential
problem affecting short-term debt was apparent in repo agreements.
are markets in which securities are exchanged for cash with an agreement to
repurchase the securities at a future date; in the transaction, securities
serve as collateral for what is effectively a cash loan.
Repo transactions can be of any maturity, but are generally of a short
maturity, ranging between an overnight loan and one year
Repo markets and amounts (Source: Hördahl and King, 2008)
order to mitigate counterparty risk (the risk of the other side reneging), some
repurchase agreements are “tri-party” repo. Under tri-party agreement, the
securities dealer delivers collateral (something pledged as security for
repayment of a loan, to be forfeited in the event of a default) to an
independent third-party custodian, such as “Euroclear” or “Clearstream”, who
will place it into a segregated tri-party account. This arrangement reduces the
administrative burden for the cash-investor. Consequently, the yield on the
investor’s cash should be slightly higher. This model is illustrated below
The model of “tri-party”
repo (Source: Choudhry, 2012)
Dealer Banks and
their Relation to the Recent Problems Affecting Money Markets in 2007-08
During the recent financial crisis,
major dealer banks played an influential role in the collapse of the money
market. The dealer bank acts as intermediary in the securities market. In
substance, they are often part of large financial organizations whose failures
can cause significant damage to the economy. As a result, dealer banks, to some
extent, are called ‘”too big to fail” and their actions need to be taken
seriously in order to avoid collapse within the money market.
In his research paper, Duffie (2010)
argues that, in the primary market, the dealer bank sometimes acts as an underwriter
that effectively buys equities (the value of the shares issued by a company) or
bonds (an agreement with legal force) from an issuer and then sells them after
a time to investors. In secondary markets, dealer banks set a ‘bid’ and ‘offer’
price at which they will trade, making profit from the difference between the
two prices. Dealer banks dominate the intermediation over-the-counter
securities market, covering bonds issued by corporations, municipalities,
certain national governments, and securitized credit products. Securities
dealers also intermediate in the market for repurchase agreements.
With the purpose to illustrate and give
a better indication of the whole situation, the chart below demonstrates that
dealer banks tend to generate stocks of collateral in excess of their total
balance sheet during periods with stable market conditions. The chart depicts a
starting value of around $2.5 trillion in 2005 Q1, that reaches a peak of
approximately $4 trillion in 2008 Q1
Collateral Stock Relative
to Total Assets (Source: Kirk, 2014)
How a Bank Run
To begin, bank runs occur when a large
number of bank customers withdraw their deposits simultaneously, perhaps due to
concerns about the bank’s solvency. A bank run is typically the result of
panic, rather than actual insolvency. Once an amount of money is deposited into
the bank, it goes into a large pool of money alongside everyone else’s. All
banks have reserve requirements; therefore some fraction of the money must be
kept while the rest is used to make loans. Reserve requirements are vital in
order to avoid a traditional-banking run, which occurs when deposits are
withdrawn at the same time.
banking, or the shadow banking system as Bernanke (2012) defined, is a diverse
set of institutions and markets that conduct traditional banking functions.
After the recent problems in money markets between 2007-08, it can be stated
that ‘‘the biggest threat to the financial system during the crisis was the run
of the repurchase market, especially the tri-party operation. Bernanke
repeatedly returned to the repo theme, urging the commissioners to include the
run on the repurchase market in their research into the causes of the crisis’’
(Bernanke, 2009, p. 1)
This section is based primarily upon the research of Gorton and
Metrick (2009), which distinguished between traditional and securities
In the traditional-banking
system, deposits are insured by the government as illustrated in Figure 1. The
investors are willing to receive similar protection to that of the traditional
banking system; therefore, the investor receives collateral in Step 1 of Figure
2. In practice, this is what is called “repo agreement”.
‘‘Haircut’’ is the difference between the initial and the repurchase
prices. It provides the investor with some protection, should the securities
(collateral) fall in value before repurchase.
Traditional and Securitized Banking (Source: Gorton and Metrick, 2009)
recent “run on repo” can be seen in the graph below, which plots a “haircut
index” from 2007 to 2008. The index rose from 0 in 2007, to nearly 45% at the
peak of the crisis in late 2008 (Gorton and Metrick, 2009).
Haircut Index from 2007 to 2009 (Source: Gorton and Metrick,
Just after the announcement of Lehman
Brothers Holdings Inc. bankruptcy, the “haircut index” increased sharply in
September 2008: ‘”As much as $75 billion of Lehman Brothers Holdings Inc. value
was destroyed by the unplanned and chaotic form of the firm’s bankruptcy filing
in September, according to an internal analysis by the company’s restructuring
(McCracken, 2008, p. 1).
Haircuts for repos accurately reflect
the overall situation in the recent market that was experiencing many problems.
The table below depicts the difference between the typical haircuts rates
applied before the peak and the rates during the financial crisis in March
2008. For example, looking at the long term investment, residential
mortgage-backed securities, AAA (‘triple A’) would have witnessed a ten time
increase in haircuts. As a consequence, an increase in haircuts causes very
substantial reductions in leverage. Leverage is the ratio of a company's loan
capital (debt) to the value of its common stock (equity). This means that lower
leverage involves buying less of an asset through use of borrowed funds
Haircuts for repos during March 2008 (Source: Shin, 2009)
Further to analysis, in order to empirically assess the
issue affecting the money markets, subtracting the interest rate on repos from
LIBOR can be used as a good measure of risk.
The results are illustrated in the figure below which shows the high
correlation between the unsecured-secured (Libor–repo) spread and the Libor-OIS
spread (Libor-OIS is the difference between LIBOR and the
overnight indexed swap
) rates). These results show
market turmoil in the interbank market was not a liquidity problem of the kind
that could be alleviated simply by central bank liquidity tools. Rather, it was
inherently a counterparty risk issue
of the other side reneging), which linked back to the underlying cause of the
High correlation between
the Libor-repo and Libor OIS spreads (Source: Taylor, 2009)
Phenomenon Affected the Money Markets?
crisis was more severe than many were willing to accept and the effect on the
global economy was the equivalent of the collapse of the banking system during
the Great Depression. After the bankruptcy of Lehman Brothers on Monday,
September 15, 2008, the consequences were disastrous; CDS
went through the roof, and American International Group
(AIG), an American multinational insurance corporation that carried a large
short position in CDSs, was facing imminent default. Rescue actions were taken
by the Treasury Secretary Henry Paulson, albeit on extremely punitive terms.
Furthermore, Lehman was previously the
fourth-largest investment bank in the USA and was one of the main market-makers
and a major issuer in commercial paper. The day after Lehman Brothers went bust
there was a run on money market funds in full swing, bringing with it
instability in the economy. In addition, it caused a panic between depositors
according to The Economist (2012):
America’s oldest money-market mutual fund declared that
investors could no longer redeem shares at the customary $1 each. In “breaking
the buck”, Reserve Primary Fund became the most prominent part of a broader
panic that saw investors pull billions from other money-market funds, a major
source of short-term lending to banks and companies
(Economist, 2012, p. 1).
The next graph shows the actual real
GDP (gross domestic product) and estimated real potential GDP in trillions of
dollars. By analysing this, it can be assumed that the average annual growth
rate starting in 2000 grew steadily without any significant shocks in the
market. It would be reasonable to assume therefore, that if the economy had not
experienced the financial crisis in 2007, the real GDP trend would have grown
alongside the real potential GDP trend. Thus, the output gap between them was
5.5% in 2011 Q4, meaning that the negative output gap caused higher
unemployment, lower growth and a fall in output.
Real output gap (Source: Treasury, 2012)
Eventually, the credit crisis rocked
the money market mutual fund industry itself. In September 2008, one of the
nation’s largest money market funds, the Reserve Primary Fund, could no longer
meet redemptions at a regular level due to the losses it incurred in
$800 million worth of Lehman Brothers’
commercial paper and floating rate notes
The effects of the financial crisis were strongly felt and even prompted a mass
exodus of withdrawals from money market funds that only halted once the
Treasury Department established a $50 billion money market
Although the panic caused by the initial “run” was halted by the guarantee,
total assets held by money market mutual funds have fallen by approximately $1
trillion since the end of 2008. This represents more than a 25% steep decline
from the peak holdings of $3.8 trillion.
Assets Held by Money Market Mutual Funds (Source:
this paper I have demonstrated the impact of repurchase agreements on the
problems affecting the money market in 2007-08. After analysis, I can
confidently conclude that all of the difficulties can be described as ‘‘a run
on repo’’. Uncertainty in the repurchase agreements led to an increase in the
repo haircuts, which was equivalent to massive withdrawals from the banking
Nevertheless, I support the statement of this article, because repo’s
undoubtedly deepened the financial crisis and were actually one of its causes.
In the cases of Lehman, AIG and other authorities, repurchase agreements played
a major role in creating systemic risk, which caused failure of our financial
All of the above mentioned
difficulties could have been avoided if authorities would have been more
prudent. However, we can hope to overcome such in the future because economists
and the governments are taking it seriously, providing liquidity support and
recapitalisation of distressed banks, further strengthening interbank lending guarantees.
I would like to emphasize that only
time will show whether we are sufficiently aware and informed after the recent
problems affecting the money market. On the other hand, it is always useful to
have a careful look back in order to understand and familiarise ourselves with
what can be learnt and better performed in the future. The main concept is that
creating a new financial mechanism is vital in order to prevent any possible
failure in the future.
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