Collateral Risk, Repo Rollover and Shadow Banking

I build a dynamic model of the shadow banking system that intermediates funds through the interbank repo market to understand its failing mechanism during the recent financial crisis. The model emphasizes a key friction, the maturity mismatch between short-term repo and long-term investments that banks need to finance. The resulting rollover risk in repo financing leads to a new contagion mechanism specific to the bilateral repo market. The default of a borrower reduces the liquidity of his lenders' asset portfolio, without reducing their equity value. But, with a less liquid portfolio, lending banks are more likely to default in the future when they start financing their own investment. So, illiquidity becomes contagious through default. Moreover, the contagious illiquidity interacts with banks' valuation over the repo contract, forming a failing mechanism. I show that, as in the crisis, when collateral risk increases unexpectedly, the haircut and interest rate of repo contracts can overshoot, triggering massive initial default, persistently hiking default rate and persistently depressed investment and output