The repo channel of cross-border lending in the European sovereign debt crisis

Abstract

I build an equilibrium model of cross-border lending to understand how shocks to repo funding and leverage induce banks to reallocate credit by region and asset type during the European sovereign debt crisis of 2010–2013. A higher collateral risk on lower-rated sovereigns induces banks to fly to liquid collateral. Banks in the periphery sovereign crisis region with worse funding conditions rebalance their loan portfolios toward risky illiquid sovereigns. The European Central Bank’s Long Term Refinancing Operations program stands as a mechanism whereby optimistic banks carried out the successful policy of the ECB to tamp down euro redenomination risk.