Effects of repos and securitization on liquidity creation in the U.S. financial institutions between 1990 and 2012 -

Abstract

Similar to traditional banking, “shadow banking” is susceptible to financial adversity and it is considered at the heart of the 2008 financial crisis. This system has been evolving for several decades prior to the crisis in a multidimensional environment where deregulation, financial innovation and credit were booming. Through shadow banking, financial practices such as securitization and repos became very prominent and the banking sector utilized these transactions to increase profitability when the traditional banking was not as lucrative. Looking at the magnitude of this crisis where liquidity dried up and investors’ confidence almost vanished, scholars have built contradictive opinions and theories around what have caused the worst systemic financial event since the Great Depression. Some scholars considered that securitization was one of the main reasons whereas others argued that the crisis was rather a “run on repos”. This paper aims to review how shadow banking developed and how the recent crisis unfolded. It provides the literature review pertaining to the empirical studies and research conducted around both securitization and repos being potential triggers of the crisis. This paper suggests a statistical model where liquidity is measured as a function of repos, securitization, financial assets and the Federal Funds Rate for the period between 1990 and 2012. It provides findings that securitization is positively correlated with liquidity whereas repos have a negative correlation. As securitization has largely contracted during the crisis, it led to the detrimental tightening of liquidity and the subsequent failure of the U.S. banking system.