Bank Runs and the Repo Market

We analyze the question whether and when access to refinancing via repurchase agreements as opposed to asset liquidation increases efficiency to financial intermediators ('banks'). By pledging assets in form of a repo contract the bank can raise cash, by this preventing to forgo returns on sold assets and avoiding costly liquidation of illiquid assets. In addition, the bank may raise even more cash by pledging assets instead of selling if she is an expert in managing the assets. On the other hand, entering in a repo increases the future debt burden of the bank. We show, if the competitive repo market is 'ignorant' about the bank's risk, it offers more liquidity than the capital market and charges an interest rate such that the bank becomes strictly more efficient. The ignorant repo market is however not sustainable and runs losses. As the repo market becomes sophisticated, it only offers as much liquidity as the capital market and charges a risk-dependent repo rate so high that the bank strictly prefers to not access the repo market. At any level of funding liquidity in excess of market value, the sophisticated repo rate explodes, i.e. there is a 'run on repo' as the repo market understands that given it is approached by the bank the asset is a lemon. We can show, if the ignorant repo market becomes sustainable and offers funding liquidity equal to market liquidity, there are gains from trade, there exist repo rates such that both the repo market and the bank are strictly better off since costly asset liquidation is prevented