Working Paper: CEPR ID: DP18499
Authors: Viral Acharya; V Ravi Anshuman; S Viswanathan
Abstract: We examine the desirability of granting "safe harbor" provisions to creditors of financial intermediaries in sale-and-repurchase (repo) contracts. Exemption from an automatic stay in bankruptcy can enable financial intermediaries to raise greater liquidity and operate at a higher leverage during normal times. This liquidity creation occurs, however, at the cost of ex-post inefficiency when there are adverse aggregate shocks to the fundamental quality of collateral underlying the contracts. When exempt from bankruptcy, creditors of highly leveraged financial intermediaries respond to such shocks by engaging in collateral liquidations. Financial arbitrage by less leveraged financial intermediaries equilibrates returns from acquiring collateral at fire-sale prices and returns from real-sector lending, inducing a rise in lending rates, a deterioration in endogenous asset quality, and in the extremis, a credit crunch for the real sector. Given this inefficiency, not granting safe harbors, i.e., requiring an automatic stay on repo contracts in bankruptcy, can be not only ex-post optimal, but also ex-ante optimal, especially for illiquid collateral with high exposure to aggregate risk.
Keywords: automatic stay; safe harbor provisions; sale and repurchase contracts; resales; credit crunch; financial crises; systemic risk
JEL Codes: G01; G21; G28; G33; D62; K11; K12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Safe harbor provisions (G28) | liquidity of financial intermediaries (G21) |
| Safe harbor provisions (G28) | leverage of financial intermediaries (G21) |
| liquidity of financial intermediaries (G21) | asset origination (G32) |
| liquidity of financial intermediaries (G21) | collateral liquidations during adverse shocks (E44) |
| collateral liquidations during adverse shocks (E44) | rise in lending rates (G21) |
| rise in lending rates (G21) | deterioration in asset quality (G32) |
| deterioration in asset quality (G32) | credit crunch for the real sector (E44) |
| Safe harbor provisions (G28) | inefficiencies during adverse economic shocks (E44) |
| Not granting safe harbors (H26) | optimal for illiquid collateral with high exposure to aggregate risk (G33) |
| Safe harbor provisions (G28) | too much origination today for too little asset origination tomorrow (G51) |