by Viral V. Acharya and T. Sabri Öncü
Although one of the main concerns of the Dodd-Frank Wall Street Reform and Consumer Protection Act soon to be signed by President Obama to law is systemic risk, it is disconcerting that the Act is completely silent about how to reform one of the systemically most important corners of Wall Street: the repo market, whose size based on daily amount outstanding now surpasses the total GDP of China and Germany combined. The financial crisis of 2007-2009 to which the Dodd-Frank Act is a response was a crisis not only of the traditional banks, but also of the shadow banks, those non-bank financial institutions that borrow short-term in rollover debt markets, leverage significantly, and lend and invest in longer-term and illiquid assets. Unlike traditional banks, shadow banks did not have access to the safety nets designed to prevent wholesale runs on banks - namely, deposit insurance and the central bank as the lender of last resort - until 2008. Although there was no wholesale run on the traditional banking system during the crisis of 2007-2009, we effectively observed a run on shadow banks that led to the demise of a significant part of the shadow banking system. Since repo financing was the basis of most of the leveraged positions of the shadow banks, a large part of the run occurred in the repo market. Indeed, the financial crisis of 2007-2009 was triggered by a shadow bank run on two Bear Stearns hedge funds speculating in the potentially illiquid subprime mortgages by borrowing short-term in the repo market.