The Run On Repo and the Liquidity Shortage Problems of the Current Global Financial Crisis: Europe vs. US

This paper discusses several key issues regarding the current Great Crisis which spreads over two periods. The first includes the 2007-2009 subprime crisis in the US, while the second extended to a twin sovereign debt and banking crisis in Europe after 2010, and persists until now. At the core of the problem is the emergence over the last thirty years of the shadow banking system, which re-created the conditions for a panic. This time the panic firstly took place in the repo market, which suffered a run when “depositors” required increasing haircuts. Fears of insolvency reduced interbank lending, and this so-called “run on repo” caused temporary disruptions in the pricing system of short-term debt markets. The subsequent crisis reduced the pool of assets considered acceptable as collateral, resulting in a liquidity shortage. With declining asset values and increasing haircuts, the US banking system was effectively insolvent for the first time since the Great Depression. Via the banking system, the American “run on repo” crisis soon infected the European financial system, causing a twin sovereign debt and banking crisis in many peripheral euro area countries, raising doubts on the survival of the euro and the regular functioning of the European Monetary System. The paper concludes that, for a successful European crisis resolution, we need to implement a fiscal union and a banking union, ensuring that fiscal and banking policies in the Eurozone be partly centralized as to meet the requirements necessary to the regular functioning of a monetary union.