Repos, Bailouts, and Instability in the Shadow Banking System

Abstract

We study a model in which a risk-pooling intermediary such as a money market mutual fund (MMMF) is exposed to runs. In addition to providing risk-pooling services to investors, the MMMF lends funds to borrowers secured by collateral as in security repurchase transactions which are frequently used by intermediaries in the shadow banking system. Inspired by events during the financial crisis, we show that bailouts of such risk-pooling intermediaries are part of an efficient social insurance scheme in the event that a run emerges. Moreover, bailouts can help minimize the costs of "runs on repos" in which there would be large-scale liquidation of collateral as a result of the liquidity crisis. However, this observation does not imply that optimal intervention completely isolates shadow-banking intermediaries from a crisis. In fact, optimal public sector intervention imposes costs on money market funds by requiring them to liquidate some collateral. On the other hand, a commitment to no bailouts contributes to financial instability as the repo market collapses in the wake of a run without a public safety net.