Flight-to-Quality via the Repo Market

The European debt crisis of 2011 has been characterized by an unprecedented divergence in borrowing costs for euro area members. While 'peripheral' government bond yields increased to unprecedented levels, yields on German and other 'core' bonds strongly declined, even though their CDS-spreads reached an all-time high in 2011. To reconcile this flight-to-quality, I propose a model of a financially integrated monetary union in which heterogeneous sovereign borrowers issue bonds subject to default risk. Investors value the collateral service of government bonds, which decreases in haircuts that are specified by the central bank in its collateral framework. In a union-wide fiscal crisis larger haircuts increase the yields of riskier government bonds and also imply a contraction of aggregate collateral supply. This makes the collateral service of the safest available bonds more valuable to investors: yields on the safest bonds decline, even though their default risk increases. Using the model, I show that a full collateral backstop policy accepting all bonds with zero haircuts during a fiscal crisis reduces the dispersion of government bond spreads and reduces sovereign risk in the monetary union