A Proposal for the Resolution of Systemically Important Assets and 

Liabilities: The Case of the Repo Market1

By

Viral V. Acharya

New York University Stern School of Business, NBER and CEPR

And

T. Sabri Öncü

Centre for Advanced Financial Research and Learning

and 

New York University Stern School of Business

Abstract

One of the several regulatory failures behind the ongoing global financial crisis that 

started in 2007 has been the regulatory focus on individual, rather than systemic, risk of 

financial institutions. Whether the recently proposed financial sector reforms can address the 

systemic risk associated with such systemically important markets as the sale and repurchase 

agreement (“repo”) market or such systemically important sectors of small institutions as the 

money market mutual funds remains debatable. Focusing on systemically important assets and 

liabilities (SIALs) rather than individual financial institutions, we propose a set of resolution 

mechanisms which is not only capable of addressing the issues of inducing market discipline 

and mitigating moral hazard, but also capable of addressing the systemic risk associated with 

the SIALs. Furthermore, because of our focus on SIALs, our proposed resolution mechanisms

would be easier to implement at the global level compared to mechanisms that operate at the 

level of individual institutional forms. We, then, outline how our approach can be specialized to 

the repo market and propose a repo resolution authority for reforming this market.

 

1

This article has been prepared for the Federal Reserve Board’s research conference on “Central Banking: Before, 

During and After the Crisis”, on March 23-24, 2012, in honor of Don Kohn. Authors are deeply indebted to Barry 

Adler, Nouriel Roubini and Matt Richardson, for collaborations and discussions on earlier work on the issue of 

resolution mechanisms for systemically important financial firms. Authors are also grateful for discussions on the 

issues of safe harbor for repo contracts and repo-market related systemic risks with Rocco Huang, Antoine Martin, 

Enrico Perotti and Mark Roe. Last, but not least, we would like to thank George Kaufman for bringing the Glass 

Proposal to our attention.
2

I. Introduction

Systemic risk can be defined broadly as the expected losses from the risk that the failure 

of a significant part of the financial sector leads to a reduction in credit availability with the 

potential for adversely affecting the real economy.

2

There are at least two contesting views on 

the causes of systemic risk. In the so-called micro-prudential view, the systemic risk arises from 

contagion of the failure of a financial institution to the rest of the financial sector whereas in 

the so-called macro-prudential view, the systemic risk arises from the collective failure of many 

financial institutions because of their common risk factor exposures. Although these two views 

are not mutually exclusive, much of the regulatory reforms take one view or the other. In the 

micro-prudential regulations, the focus is on the systemically important financial institutions 

(SIFIs) whereas in the macro-prudential regulations, the focus is (also) on the risk of a crisis in 

the financial sector and its spillover to the economy at large. Taking the micro-prudential view, 

both the Dodd-Frank Wall Street Regulation and Consumer Protection Act (DFA) signed into law 

by President Obama in July 2010 in the U.S. and, internationally, Basel III focus on single 

financial institutions.

SIFIs consist of financial intermediaries that are not only commercial banks taking 

deposits and making loans, but also include investment banks, money market funds, mutual 

funds, insurance firms and potentially even hedge funds, whose failure poses a systemic risk to 

the financial system. This systemic risk can come through multiple forms which include 

counterparty risk on other financial institutions, asset liquidations that can produce a 

depressing effect on asset prices, liquidity hoarding that raises funding costs in interbank 

markets even for safe firms, and an information contagion effect resulting in a significant 

reduction in overall market liquidity. Therefore, any mechanism set up by the regulators to deal 

with the insolvency of SIFIs must follow at least four basic principles (Acharya, Adler, 

Richardson and Roubini, 2010):

1) The counterparty risk of the SIFIs must be contained through regulations including

the imposition of capital requirements, margin rules, and limitation on risky 

investments ex ante.

2) There needs to be a procedure for dealing with large amounts of illiquid assets 

whose forced sales can have a catastrophic effect on the financial system.

3) The resolution mechanism should be able to identify insolvent institutions promptly 

as they can become pockets where financial resources of the economy can get 

trapped, potentially creating funding problems even for otherwise solvent firms.

 

2

This definition is based on Acharya, Pedersen, Philippon and Richardson (2010). See, for example, Kaufman and 

Scott (2003) for other definitions.
3

4) There must be well-defined rules for what happens to the liabilities of the financial 

institution when it fails, for otherwise a run on most of the institution’s liabilities will 

occur, potentially leading to a system-wide run. 

Furthermore, since many SIFIs operate across borders (global SIFIs – G-SIFIs) and, as we have 

witnessed in the recent financial crisis, their failure can threaten the integrity of the entire 

global financial system, to the above four principles we must add:

5) The national resolution mechanisms should be amenable to easy international 

coordination for the effective resolution of G-SIFIs. 

When the collapse or near collapse of such financial institutions as Bear Stearns, 

Lehman Brothers, AIG and the like after the onset of the global financial crisis in 2007 made the 

inability of the existing resolution mechanisms to deal with the failure of SIFIs clear, the U.S. 

was the first mover with the Dodd Frank Act. To address the concerns about the inability of the 

existing resolution mechanisms to handle the failure of SIFIs, Title II of the DFA created the 

Orderly Liquidation Authority (OLA) as a new mechanism. However, as it is stated fairly clearly 

in Title II of the DFA, the OLA is not a resolution but liquidation mechanism.

3

Putting aside the question of whether such liquidation – rather than a resolution –

authority focusing on individual financial institutions is sufficient to achieve the DFA-stated 

goals of inducing market discipline and mitigating moral hazard, the question of whether the 

OLA can address the systemic risk associated with such systemically important markets as the 

sale and repurchase agreement (“repo”) market or such systemically important sectors of small 

institutions as the money market mutual funds remains debatable.4Although we discuss our 

concerns regarding the OLA in the next section in detail, let us give a simple example from 

September, 2008, to illustrate how the OLA may fail in containing the systemic risk:

After the Lehman Brothers’ bankruptcy filed on September 15, 2008, its outstanding 

debt collapsed in price almost immediately. Since one of the largest money market mutual 

funds (MMMFs), the Reserve Primary Fund, was highly exposed to Lehman Brothers' collapsing 

short-term debt, the next day its net asset value (NAV) fell below par. Since MMMFs offer 

stable NAV and investors can redeem anytime at par, an immediate run on the Reserve Primary 

Fund occurred, causing it to shut down. This failure opened up the possibility that other 

MMMFs were similarly exposed and a run on the MMMFs started. Since MMMFs are a primary 

source for the commercial paper market, this run opened up the possibility of capital shortfalls 

at many financial institutions that needed to roll over commercial paper. Only after the 

government guaranteed the MMMF deposits 100% the run came to a halt and the slide was 

stopped.

 

3

HR 4173, Title II, “Orderly Liquidation Authority,” Sec. 204, “Orderly Liquidation of Covered Financial Companies.”

4

See, Acharya, Adler, Richardson, and Roubini (2010) and Acharya, Cooley, Richardson, and Walter (2011) for 

detailed discussions.
4

Under the OLA, if invoked as described in Title II of the DFA, the Reserve Primary Fund 

would have been placed into a receivership administered by the Federal Deposit Insurance

Corporation (FDIC) to be liquidated (assuming that the Reserve Primary Fund – or the moneymarket funds sector as a whole – were deemed systemically important by the Financial Stability 

Oversight Council, set up under the DFA). Although the FDIC could have borrowed from the 

Treasury to finance the liquidation, if the proceeds from liquidation were insufficient to repay 

the Treasury, the FDIC would have had to claw back from creditors any amounts received in 

excess of what they would have received in an ordinary liquidation.5 Given that the investors of

MMMFs were offered stable NAV and promised that they could redeem anytime at par, it is 

evident that a liquidation authority such as the OLA – which with its focus on eliminating the 

moral hazard associated with the “too-big-to-fail” status recovers from creditors any amounts 

received in excess of what they would have received in an ordinary liquidation – neither could 

have nor will have stopped the slide in such an episode.

6

An orderly liquidation of the assets of 

the Reserve Primary Fund was not even an issue then. Furthermore, neither was the Reserve 

Primary Fund “too-big-to-fail” despite its $64.8 billion worth of assets prior to its shut down, 

nor was it even an SIFI on its own right. What was systemically important in September, 2008, 

was the $3.5 trillion financial sector of MMMFs. The intervention had to be done at the sector 

level to avoid a possible collapse of the entire financial system.

Another problem associated with the OLA is that it does not apply to the foreign 

subsidiaries of the G-SIFIs. For example, when Lehman Brothers filed for Chapter 11 protection 

in September, 2008, this action triggered well over 60 insolvency proceedings worldwide some 

of which were particularly harmful to global financial stability (Acharya, Adler and Richardson, 

2011). Even if the OLA existed at the time of the Lehman Brothers’ insolvency, the assets and 

liabilities of its U.K. prime brokerage would have been resolved under the U.K. law. Although in 

response to the G20 call for action, the Financial Stability Board (FSB) issued recently a new

international standard for resolution mechanisms “so that any financial institution, whatever its 

size and complexity, can be resolved without disruption to the financial system and without 

taxpayer solvency support”7, it is still unclear how this new standard will be implemented in the 

U.S. and can be reconciled with the OLA.

Furthermore, even the FSB issued new international standard described in its 

November, 2011, “Key Attributes” document8focuses on individual financial institutions that 

are to be deemed globally systemically important, that is, G-SIFI. To see why this might be a 

problem, take, for example, the re-hypothecation of hedge funds’ assets held at Lehman’s U.K. 

prime brokerage unit during Lehman’s bankruptcy. Under the U.K. law (which was changed 

later), these assets became Lehman’s creditors take. This led not only to runs on hedge funds,

 

5

If there is any remaining shortfall, the FDIC can levy an assessment on all financial companies deemed an SIFI by 

the involved regulators.

6

Had the MMMFs offered floating rather than stable NAV, there might not have been a run on the Reserve 

Primary Fund, entailing the system-wide run on all MMMFs, of course. However, in such a scenario, all MMMFs 

would be disintermediated by the bank money market accounts rapidly.

7 www.financialstabilityboard.org/press/pr_111104dd.pdf

8 www.financialstabilityboard.org/publications/r_111104bb.pdf
5

but also to overall uncertainty about which assets at financial institutions were safe and which 

were not (Acharya, Adler and Richardson, 2011). No resolution mechanism focusing on G-SIFIs, 

even if internationally coordinated as described in “Key Attributes”, could have worked quickly 

enough to stop these effects.

With these in mind and taking the macro-prudential view, we propose an alternative set 

of resolution mechanisms, based on the insights of Acharya, Adler and Richardson (2011),

which is not at the level of SIFIs, but at the level of systemically important assets and liabilities 

(SIALs) of financial institutions, whether these institutions are deemed systemically important

or not. Systemically important liabilities (SILs) can be defined broadly as those liabilities of 

highly-leveraged entities that are assets of other highly-leveraged entities and therefore when 

faced with haircuts in case of default would trigger runs on other entities. Examples of SILs

include deposits, repos and over-the-counter (OTC) derivatives. Similarly, systemically 

important assets (SIAs) can be defined broadly as those assets that are either SILs of other 

highly-leveraged entities or potentially illiquid, high risk assets financed through SILs. Examples

of SIAs include exposures to SIFIs, asset-backed commercial paper (ABCP) and risky repo 

collaterals such as mortgage-backed securities (MBSs). To the extent possible, the set of 

mechanisms should be expanded to cover as many classes of systemically important assets and

liabilities as possible.

9

What we propose is that instead of attempting regulation of systemically important 

financial institutions (a “top down” approach to regulating systemically important assets and 

liabilities), prudential regulation be built in the form of a “bottom up” approach – one that 

works at the level of the SIALs rather than at the level of the SIFI that owns them. Under the 

“bottom-up” approach there would be an automatic stabilizer built for each SIAL. The 

automatic stabilizers could be in the form of government-provided but appropriately-charged 

deposit insurance, centrally cleared SIALs with initial and variation margins or haircuts charged 

by a clearinghouse or dedicated resolution authority for those SIALs, and in extreme cases, 

lender-of-last-resort from the central bank against eligible assets (but to avoid moral hazard, 

only to firms that pay a market-rate fee). This way, when an SIFI fails, it is not the orderly 

resolution of an individual SIFI that has to be effected, but rather the resolution of its various 

SIALs; the parts of its capital structure that are not systemically important would be resolved by 

market-determined contracts and relevant bankruptcy procedures. A particularly attractive 

feature of the “bottom up” approach is that it requires no uniform institution-level insolvency 

process and therefore might be the simplest way of achieving international agreement on 

resolving the financial distress of G-SIFIs (as long as there is global agreement on resolution 

mechanisms for SIALs). 

We present as a leading example of our approach the systemically important assets and 

liabilities underlying the repo market and propose a potential repo resolution authority for 

 

9

A detailed discussion of our approach, originally proposed by Acharya, Adler and Richardson (2011), can be found 

in their document whereas a detailed analysis of many reasons that warrant macro-prudential regulations rather 

than micro-prudential regulations can be found in Acharya (2011).
6

reforming the repo market to illustrate how our approach can be implemented for this 

particular class of SIALs.10 A repurchase agreement – also known as a “sale and repurchase 

agreement,” or more popularly as a repo – is a short-term transaction between two parties in 

which one party borrows cash from the other by pledging a financial security as collateral. One 

important feature of the U.S. repo market is that all transactions that fall under the umbrella of 

repos are exempt from the automatic stay in bankruptcy and therefore all repo transactions 

can be liquidated following a bankruptcy filing. As is well known, the ongoing global financial 

crisis was triggered in the summer of 2007 essentially by a “run” on two Bear Stearns hedge 

funds speculating in the potentially illiquid subprime mortgages by borrowing short-term in the 

U.S. repo market and eventually on Bear Stearns in March of 2008. We describe these “repo 

bank runs” and the role the fire-sale liquidation of the repo collaterals – that are exempt from 

the automatic stay – played in the ensuing systemic crisis (in Section III.2 in detail).

Our proposal for resolving repo runs is to create a “Repo Resolution Authority” in each 

jurisdiction with significant repo transactions. The repo collaterals will in general not be 

exempt from bankruptcy of borrowing financial firms, except when the collateral is in the form 

of highest quality government or government-guaranteed bonds. All other repo collateral on 

defaulting repo transactions will be resolved by the repo resolution authority, which makes an 

immediate “liquidity” payment to repo financiers. The immediate payment is based on 

conservative assumptions (a “haircut”) about the liquidation proceeds from the collateral. The 

realized proceeds will in general exceed or be smaller than the conservative payment and will 

be repatriated or clawed-back from repo financiers. In the process, however, the repo 

resolution authority takes on credit risk of the repo financiers. To manage this credit risk and to 

attenuate the moral hazard induced on part of repo financiers, the repo resolution authority 

would include as eligible only relatively high-quality collateral; charge repo financiers an ex ante

fee for the liquidity enhancement provided in case of default in a manner that is commensurate 

with the residual credit risk borne by the facility; require that eligible repo financiers meet prespecified solvency criteria; and impose a concentration limit at the level of individual repo 

financiers, as well as on the financier’s overall portfolio size. 

In effect, the repo resolution authority does resemble a clearinghouse for repo 

contracts, in that it has the right to suspend automatic conversion of repo claims into 

liquidations of underlying collateral, it takes on the liquidation rights itself but ensures that its 

provision of liquidity to the market in case of default does not engender insolvency concerns. 

The repo financiers, which face participation criteria and haircuts in good times, would pass on 

the relevant costs to borrowers in the repo markets. Collateral that is not eligible for the repo 

resolution authority would remain outside of bankruptcy exemption as well as outside of the 

liquidity enhancement provided by the repo resolution authority; these contracts would thus 

be relatively subordinated in the capital structure of financial firms and they could be subject to 

prudential capital requirements or minimum haircut/over-collateralization requirements (as 

with other parts of the capital structure of financial firms).

 

10 The proposal and discussion to follow elaborate on the initial case the authors made in (Acharya and Öncü, 

2010).
7

We organize the rest of the paper as follows: In Section II, we describe some specific 

details of the DFA, and evaluate it with respect to the efficiency of the process and its ability to 

mitigate moral hazard and systemic risk. In Section III, we describe how the repo market came 

to play such an important role in securitized banking in the U.S., discuss its critical role in the 

form of runs in the crisis, and argue a case for reforming the repo market based on our analysis. 

We then outline in Section IV our proposed “Repo Resolution Authority” for such reform, and 

compare and contrast it with an interesting precedent, the Federal Liquidation Corporation 

proposed by Senator Glass in the early 1930s, in Section V. Finally, in Section VI, we discuss how 

our proposed resolution mechanism for the repo market may be coordinated globally and 

present our concluding remarks. 

II. The Dodd-Frank Resolution Mechanism for Nonbank SIFIs

A central objective of the DFA is to create a new resolution mechanism for nonbank 

SIFIs and bring them within the FDIC insurance model. Established in 1933, the FDIC is an 

independent federal agency of the U.S. that insures deposits at its member banks and savings 

and loan institutions, currently up to $250,000 per depositor per institution. If a member 

institution fails, it is taken into receivership by the FDIC, which within a few days either 

facilitates a merger with another FDIC-insured institution or pays each depositor for the insured 

portion of their accounts at the closed institution and then liquidates the closed institution’s 

assets. Since the Federal Deposit Insurance Reform Act of 2005 signed into law by President 

Bush in February 2006 and became effective March 31, 2006, the FDIC finances the liquidations 

from the Deposit Insurance Fund (DFI) to which member institutions pay an ex ante insurance 

fee based on the balance of insured deposits, as well as on the FDIC assessed risk the institution 

poses to the DFI.11 And, if further funds are needed, the FDIC can draw on a line of credit with 

the U.S. Treasury. Furthermore, the FDIC deposit insurance is backed by the full faith and credit

of the U.S. government, which means that the resources of the U.S. government stand behind 

FDIC-insured depositors. 

According to Sheila Bair (FDIC, 2011), the former chair of the FDIC, the DFA resolution 

mechanism has these basic elements:

1) Title I: The establishment of the Financial Stability Oversight Council (FSOC), chaired 

by the Secretary of the Treasury and comprised of members from the other financial 

regulatory agencies, with the responsibility of designating SIFIs or “covered 

companies" that will be subject to heightened supervision by the Federal Reserve 

Board of Governors (FRB);

2) Title I: The requirement for the preparation of detailed resolution plans – often 

referred to as “living wills" – by covered companies to demonstrate that they are 

resolvable under the bankruptcy laws if they run into severe financial stress and 

 

11 For a history prior to 2006, see: http://www.fdic.gov/deposit/insurance/history.html
8

provide valuable advance information that will assist in implementing their orderly 

liquidation, if necessary;

3) Title II: The prohibition of bailouts of individual companies by providing an 

alternative to bankruptcy with the establishment of an OLA, which allows the FDIC 

to resolve nonbank financial companies by using many of the same trustee powers 

over systemic nonbank financial companies that it has long used to manage failed 

bank receiverships.

The DFA characterizes nonbank financial companies that can be covered under the OLA 

quite broadly. The companies eligible for covered financial company (CFC) designation include 

bank holding companies, nonbank financial companies supervised by the FRB and any other 

company predominantly engaged in activities that the FRB determined financial in nature, as 

well as the U.S. subsidiaries of these eligible companies. However, the DFA resolution 

mechanism is an iterative process: First comes the attempted resolution as described in the 

living wills through the bankruptcy code in a manner that “does not pose a systemic risk”. If the 

attempt fails, then follows the “orderly liquidation” under the OLA, presumably avoiding the 

systemic risk and therefore the “too-big-fail” bailout of the SIFIs with the tax-payer funds. Or so 

goes the theory.

The above is one of the main problems associated with the new DFA resolution 

mechanism. Under the DFA resolution mechanism, a failed nonbank SIFI goes through normal 

bankruptcy or other applicable insolvency law first. Only after the Secretary of the Treasury,

upon recommendation by the FRB by a two-thirds vote and a similar vote by the FDIC (or, in 

some cases, other involved regulators), in consultation with the President, determines that the 

failed financial company should be subject to OLA and the board of directors of the CFC 

approves the Secretary of the Treasury’s determination, the FDIC is appointed as receiver of the 

CFC. Otherwise, the Secretary of the Treasury files a petition with the U. S. District Court for the 

District of Columbia seeking judicial review of his decision. If the District Court finds the 

Secretary’s petition “arbitrary and capricious” within 24 hours, then the petition is denied. 

Otherwise, either through Court approval or, if the District Court does not make a 

determination within 24 hours of receipt of the petition, through operation of law, the petition 

is granted and the FDIC is appointed as receiver of the CFC. If the FDIC is appointed as receiver 

of the CFC either through the first or the second of the above processes, then the board of 

directors of the CFC – as well as other aggrieved parties – has 30 days to appeal the 

appointment of the FDIC as receiver.

There are at least two issues with the above: The first issue is that the regulators may 

wait too long to intervene and have no choice but to put the SIFI through the liquidation 

process. This is a very risky proposition in terms of systemic risk, as we describe below. The 

second issue is that, despite the commendable efforts to expedite the liquidation process, the 

procedure may not be sufficiently fast to contain the ensuing run on liabilities that can be 
9

pulled immediately. Because of these uncertainties underlying the OLA process, it is highly likely

that (Acharya, Adler, Richardson and Roubini, 2010):

1) Runs on these and other short-term liabilities of the institution will occur in 

anticipation of such determination, creating a self-fulfilling OLA event; 

2) Holders of the institution’s longer-term debt and equity will try to sell their holdings 

in secondary markets, putting pressure on the financial firm’s position in capital 

markets;

3) Runs on similar financial firms may occur, essentially leading to the regulators having 

no choice but an OLA determination for a significant part of the financial sector.

While any insolvency procedure is subject to these problems, it is unclear how the DFA 

resolution mechanism will address them through the OLA. 

Another problem associated with the DFA resolution mechanism is the Orderly 

Liquidation Fund (OLF) on which the FDIC will be authorized to draw as the receiver. In the 

originally proposed bill, this fund was to be financed ex ante by risk-based assessments of the 

CFCs in such a way that the more systemically important the CFC, the larger the assessment. In 

the signed law, however, this provision was dropped. Instead, the FDIC will borrow from the 

Treasury and will repay the borrowings from creditors who receive funds in the OLA process 

that are greater than what they would have received in normal liquidation under the 

bankruptcy code. And, if this claw-back is not sufficient, the FDIC will repay from ex post

assessments on bank holding companies with total assets of $50 billion or more and on any 

nonbank SIFI.

Although the FDIC’s use of the OLF is discretionary, let us suppose that the FDIC used

the OLF to finance the failed CFC as intended by the DFA. That is, the failed CFC is supplied with 

liquidity but a portion of its assets – presumably equal in value to the loans extended – is

retained for the OLF. However, if the CFC has failed because the value of its assets is less than 

that of its obligations, unless it is subsidized in receivership its counterparties will not be paid in 

full and hence the risk of contagion will remain. Therefore, the OLA might not contain the 

systemic risk that the failure of a large, interconnected SIFI might undermine the financial 

system. 

Consequently, it might be expected that the FDIC as the receiver will not use the OLF to 

achieve an orderly liquidation of the assets of the failed CFC, but rather will use it to bailout the 

failed CFC creditors. That is, to prevent contagion, the FDIC might be expected to satisfy

counterparty claims that could not be paid from the assets of the failed CFC even if the assets 

are liquidated in an “orderly” fashion. This very likely to materialize bailout expectation – a

perceived insurance that covers the losses of the creditors – creates moral hazard, the very risk 

the DFA aims to eliminate.
10

If, on the other hand, the claw-back provision of the OLA is indeed credible and, as a 

result, the creditors become the de facto insurers, then the DFA would realign incentives, 

eliminating the potential moral hazard as intended. The question then remains whether the 

FDIC as the receiver can claw back the moneys paid to creditors in excess of what they would 

have received in normal liquidation under the bankruptcy code after the “orderly” liquidation. If 

the perception is that the receiver can, then the bailout will have no effect. Under this scenario, 

however, as soon as it is remotely perceived that a CFC will be subject to the OLA, a large scale

run on the systemically important liabilities, i.e., SILs of the failed CFC and similar financial 

institutions will occur.

Furthermore, even after ignoring all of the problems discussed above, there remains the 

question of who picks up the bill if all else fails to repay the Treasury. The DFA answer to this 

question is the financial industry itself. But the DFA imposed ex post assessments require that 

even the prudent financial companies pay for the failure of the others. This would be a problem

even from merely an ex post perspective as the costs to the financial system could be 

substantial and might weigh against the ability of the system to provide credit, creating an 

illiquid financial system the DFA is intended to avoid. From an ex ante perspective the problem 

is even worse. The DFA plan for even the healthy financial institutions to pay the creditors of 

failed CFCs creates a free rider problem. This encourages all financial institutions to take 

excessive risks, leading to an even more fragile financial system and hence increasing the 

likelihood of deep financial crises.

Yet another principal difficulty in writing insolvency law for SIFIs is the issue of how to 

treat their so-called qualified financial contracts (QFCs). In the U.S. under the current 

bankruptcy code, QFCs include forwards, swaps, repos and other OTC derivative contracts, and 

are essential for the functioning of SIFIs. In fact, what differentiates SIFIs from other financial 

institutions is essentially their substantial presence in the market for QFCs. The QFCs are 

related to our notion of systemically important assets and liabilities (SIALs), and whether a QFC 

is an SIL or SIA depends on the position taken in the QFC, as well as on the market conditions.

For example, a long position in a call option is an SIA irrespective of the market conditions while 

a long position in an interest rate swap – that is, a fixed-payer interest rate swap – may be 

either an SIL or SIA depending on the market conditions. 

The current U.S. bankruptcy code, enacted in 1978, initially provided a safe harbor from

automatic stay and other bankruptcy provisions for commodity and forward contracts. In this 

context, safe harbor means exemption from bankruptcy proceeding whereas automatic stay

means an injunction issued automatically by the bankruptcy court upon the filing of a 

bankruptcy that prohibits collection against the debtor or the debtor’s property. The safe 

harbor clause allows the counterparty to the failed financial institution to terminate the QFCs

and take control of what it is owed from the assets of the failed institution. With the 

Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) enacted in 2005, the safe 

harbor exception has been broadly expanded to cover such QFCs as cross-netting provisions, 

credit default swaps, interest rate swaps and margin loans among other arrangements, 

including repos. We discuss how the BAPCPA reform of 2005 affected the repos in detail in 

subsequent sections. An excellent discussion of the advantages and disadvantages of the safe 
11

harbor clauses for QFCs can be found in Tuckman (2010), and we briefly review these below. 

See also Edwards and Morrison (2004), Jackson (2009), Miller (2009), Faubus (2010), and Roe 

(2010), among others.

The original motivation for the safe harbor status of the QFCs in the bankruptcy code 

was to reduce the systemic risk in the financial system. Because most QFCs are either hedged or 

used as hedges continually, tying up counterparty QFC positions in bankruptcy would unwind

the hedges in place and lead to wide-scale risk exposures for leveraged institutions. Moreover, 

if the underlying collaterals are tied up, the loss in potential liquidity for the counterparty might 

also have serious consequences. Either of these problems, together with uncertainty about 

when the failed institution QFCs would be cleared, could cause the associated markets to 

freeze. Hence, the safe harbor status granted to the QFCs has some merit.

However, the reduction in systemic risk arising from QFCs avoiding the automatic stay 

and related provisions in bankruptcy is replaced by another form of systemic risk involving fire 

sales of QFCs and funding illiquidity spirals. For example, consider the repo agreements. Many 

repo financiers are money market mutual funds (MMMFs) subject to restrictions on average 

maturity of their investments. When they face default on a repo of a long-term asset such as 

mortgage-backed security (MBS), their typically overnight role as a lender in a repo financing 

gets translated into being the holder of a long-term asset. As a result, the MMMFs as the repo 

financier may be forced to liquidate the asset upon failure of their repo counterparty. Similarly, 

counterparties of a failing firm in a derivative contract might need to terminate and replace the 

contract right away as it might be serving as a hedge of some financial risk. Then, as

counterparties liquidate the repo collateral all at once, or terminate and replace their derivative 

positions simultaneously, with the large number of trades and multiple participants money 

markets and derivatives markets can be destabilized. In the recent crisis, there was 

considerable concern that a bankruptcy of SIFIs like AIG, Merrill Lynch or Citigroup would have 

forced large amounts of mortgage-backed derivatives to be sold on the marketplace. Given 

widespread exposure to these securities by other financial institutions, these losses would have 

caused a funding liquidity freeze, resulting in even more sales and losses and therefore leading 

to a death spiral of large parts of the financial system. 

An equally strong argument against the safe harbor is the regulatory arbitrage it creates 

within the system: counterparties can build up large concentrated exposures without much 

consequence. Specifically, because most QFCs can be engineered to mimic an underlying asset, 

there exist at least two claims with essentially the same economic behavior. However, these 

essentially same claims may be subject to different rules and therefore may have different 

implications for ex ante risks. For example, consider again a repo against an AAA-rated MBS. If 

the MBS is held on the banking book of an SIFI, it gets treated as a long-term holding subject 

typically to capital requirement against potential credit risk for a year. If the MBS is instead on 

the trading book as an available-for-sale security that is being rolled overnight in repo markets, 

then it gets treated as being sold and repurchased each day, so that as far as its capital 

requirement concerned, it is subject to market risk for only one day. 
12

This transformation of a long-term asset into an overnight asset is primarily because of

the repo financier’s right to take over the asset in case of failure of the repo counterparty. 

However, as explained above, in many cases repo financiers themselves cannot own these 

assets in the long run and must liquidate them upon failure of their repo counterparty. 

Therefore, the migration of the MBS from the banking to trading book lowers the capital 

requirement against it throughout the financial system, since no institution is holding capital for 

a scenario where there is systemic illiquidity under which some institution — most likely an 

institution which incurred a huge illiquidity discount in the fire sale of the asset — must hold 

the asset for the long run. 

Such distortions push counterparties toward designing complex products that can help 

shift assets from the banking to the trading book, which are then financed using short-term 

repos in the repo market, away from the monitoring of regulators and at substantially lower 

capital requirements. The effective outcome is tremendous liquidity in repo markets for these 

products in good times, with systemic stress and fragility when the products are anticipated to 

experience losses. The expansion of safe harbor to repo transactions with underlying mortgagebased assets in the Bankruptcy Act of 2005 has thus been cited as one of the reasons for the 

growth in mortgage-based derivatives over the period from 2005 to 2007. 

The DFA essentially treats QFCs the same way the FDIC treats them in receiverships not 

covered by the Act. That is, at the end of the first business day after a receivership commences, 

counterparties would be able to exercise their rights against the CFC such as to terminate, net 

out, set off and apply collateral with respect to all their QFCs. Therefore, although the provision 

of a safe harbor under the DFA is not identical to that of the bankruptcy code, QFCs still benefit 

from special protection. An exception is that until the end of the first business day after 

commencement, the FDIC would be allowed to transfer all (and only all) of the QFCs between 

the CFC and a given counterparty. Although such exceptions to the safe harbor clause make 

some sense to the extent the systemic risk of financial institutions might vary from one 

situation to the next, a better approach would be (Acharya, Adler and Richardson, 2011) as 

follows: 

1) QFCs that are liquid should keep the exemption. Liquid QFCs will cause less systemic 

risk in fire sales, yet still allow counterparties to manage their risk without the 

uncertainty generated by the bankruptcy of a SIFI. Moreover, in order to get the 

exemption, counterparties will have an incentive to trade in liquid QFCs. 

2) QFCs that are illiquid — or potentially illiquid (such as repo contracts on MBSs) —

should be subject to the ordinary rules of bankruptcy including the automatic stay. 

The systemic risk underlying fire sales would be avoided, especially given that 

complex, illiquid transactions are more difficult to unwind. Of course, this would 

come at the cost of general liquidity of the counterparties and impact their ability to 

manage risk. To the extent regulators impose capital and liquidity standards, QFCs 

subject to the stay should apply higher liquidity standards to the counterparty.
13

Lastly, as we discussed in the previous section at length, the DFA resolution mechanism 

is completely domestic. This is an important problem because many U.S. SIFIs operate globally, 

so that they are G-SIFIs. Furthermore, many G-SIFIs incorporated in other countries operate in 

the U.S. as well. If a G-SIFI operating in the U.S. needs to be liquidated in an orderly manner,

the DFA cannot specify how its systemically important assets and liabilities (SIALs) in other 

countries will be resolved. The resolution of G-SIFIs requires an international arrangement. 

Although the Financial Stability Board – established by G7 in 1999 and re-established by G20 in 

2009 to coordinate at the international level the work of national financial authorities and 

international standard setting bodies – issued a new international standard for resolution 

mechanisms in November, 2011, as we mentioned earlier, no international resolution 

mechanism has yet been proposed by any international body. This leaves the global financial 

system still wide-open to significant systemic risk that may result from a disorderly liquidation 

of SIALs somewhere in the world, thereby requiring “too-big-to-fail” or “too-many-to-fail” or 

“too-interconnected-fail” bailouts of SIFIs everywhere, even if the DFA resolution mechanism 

manages to avoid a disorderly liquidation of associated U.S. based SIALs in spite of the 

problems we pointed out above. 

III. The U.S. Repo Market

Recall that a repurchase agreement is a short-term transaction between two parties in 

which one party borrows cash from the other by pledging a financial security as collateral. In a 

repo transaction, the collateral provider enters into a “sale and repurchase agreement” or, in 

short, a repo. The cash provider enters into a “purchase and resale agreement”, or, in short, a 

reverse repo. Hence, every repo is also a reverse repo and vice versa. The perspective depends 

on who is the seller and who is the purchaser. 

The day the repo is initiated is called the sale date, and the day the repo is terminated is 

called the purchase date. The difference – if any – between the values of the collateral and loan 

is called the “haircut” or margin. The haircut – if any – is a protection against the counterparty 

risk in the transaction. In principle either the cash or the collateral provider may be subject to a 

haircut. When the cash provider is subject to a haircut, then the haircut is the margin required 

by the collateral provider as protection against the potential value gain of the collateral in case 

the cash provider fails to deliver the collateral on the purchase date so that the collateral 

provider has to buy a substitute. When the collateral provider is subject to a haircut, then the 

haircut is the margin required by the cash provider as protection against the potential value 

loss of the collateral in case the collateral provider fails to come back, and the cash provider has 

to take ownership of the collateral, sell it and recover the loss.

In the U.S. repo market, loans are mostly extended overnight – that is, they are one-day 

transactions. Overnight repos constitute about half of all repo transactions, and most of them 

are open, i.e., they roll over automatically until either party chooses to exit. Other repo 

transactions, called term repos, have terms longer than one day but shorter than one year, 

although the vast majority have maturities of three months or less. Participants in the repo 

market include commercial banks, investment banks, hedge funds, mutual funds, pension
14

funds, money market funds, municipalities, corporations, and other owners of large amounts of 

idle cash, as well as the Fed and primary securities dealers.

The Fed participates in the repo market mainly to implement its monetary policy; 

primary securities dealers participate mostly to finance their market-making and risk 

management activities. On the other hand, owners of large amounts of idle cash engage in the 

repo market mainly for two reasons: (1) to get better interest rates in the repo market 

compared with deposits at commercial banks, and (2) for insurance purposes; while large 

deposits at commercial banks are not insured, deposits at “repo banks” are secured by debt 

used as collateral. 

III.I Evolution of the U.S. Repo Market

The repos were introduced to the U.S. financial market by the Federal Reserve in 1917. 

Repos allowed the Fed to extend credit to its member banks, after a war-time tax on interest 

payments on commercial paper had made it difficult for banks to raise funds in the commercial 

paper market. Later in the 1920s, the New York Fed used repos secured with bankers’ 

acceptances to extend credit to dealers to encourage the development of a liquid secondary 

market for acceptances. Repos fell from grace during the Great Depression after massive bank 

failures and low interest rates, only to make a comeback after the Treasury-Federal Reserve 

Accord of 1951 “that renewed emphasis on controlling inflation rather than keeping interest 

rates low” (Garbade, 2006).

Early repos in the U.S. had two distinguishing features. First, accrued interest was 

excluded from the price of the repo securities. Second, even though the creditor could sell or 

deliver the repo securities to settle a prior sale at prices that included the accrued interest 

during the term of the repo, ownership of the repo securities rested with the debtor. These 

features had the following implications: (1) the repo securities were underpriced; (2) the 

creditor had to remit to the debtor any coupon payments on the repo securities during the 

term of the repo; and (3) in the event of a bankruptcy of the debtor, the repo securities were 

subject to automatic stay; that is, the creditor could not take ownership of the repo securities 

and sell them immediately.12 These features remained intact until the early 1980s.

 

12 However, there appears to have been some deliberate vagueness about this until a government securities 

dealer, Lombard-Wall, collapsed in 1982, and the Federal Bankruptcy Court of New York imposed an automatic 

stay on the repo securities that Lombard-Wall had used as collateral. See:

http://www.nytimes.com/1982/12/17/business/lombard-wall.html

This point had always been uncertain until the 1982 and 1984 amendments to Code 11 of the U.S. Bankruptcy 

Code. In a “true sale,” the buyer is not subject to the automatic stay. For instance, if an automobile dealer bought 

a car from GM the day before it filed for bankruptcy, it could resell the car without asking for permission of the 

court. However, if the deal were financed by GM, the dealer would need a court order to sell the car. The repo 

transactions are structured formally as a true sale, free of the automatic stay. The question was, and still is, 

whether courts would reclassify it as a secured transaction. Before 1982/4, this would inflict the stay on the 

collateral taker. After 1982/4, it would only affect the rights of a secured party, which are more limited than the 

rights of a buyer.
15

During the period of high inflation in the 1970s and early 1980s, rising short-term 

interest rates made repos a highly attractive short-term investment to holders of large amounts 

of idle cash. Increasing numbers of corporations, local and state governments, and at the 

encouragement of securities dealers, even school districts and other small creditors started 

depositing their idle cash in “repo banks” to earn interest rather than depositing money in 

commercial banks that did not pay interest on demand deposits. Furthermore, the U.S. 

Treasury started borrowing heavily after 1974, eventually changing the status of the U.S. from a 

creditor to a debtor nation and increasing the volume of marketable Treasury debt significantly. 

This led to a parallel growth in government securities dealers’ positions and financing, and the 

repo market grew by leaps and bounds. Figure 1 depicts the size of the market from January 

1970 to January 1986, as reported by the Federal Reserve Board.

The first important change to repo contracts came after the spectacular collapse of 

Drysdale Government Securities Inc. in 1982. Despite its limited equity, Drysdale had been 

acquiring substantial amounts of debt securities through reverse repos and at prices that 

excluded the accrued interest. Drysdale then short sold these securities to third parties at 

prices that included the accrued interest. Drysdale used the surplus thus generated to raise 

more capital and to make interest payments to its reverse repo counterparties. However, when 

interest rates moved against Drysdale in May 1982, the cumulative losses on its interest rate 

bets depleted its capital. On May 17, 1982, Drysdale failed to pay the interest on the securities 

it had borrowed. When that news hit the repo market, it came to a near halt, forcing the Fed to 

intervene as a lender of last resort to calm fears and prevent a collapse. This near collapse 

exposed the systemic risk associated with the exclusion of accrued interest, and therefore, 

largely at the encouragement of the Federal Reserve Bank of New York, inclusion of accrued 

interest in the invoice price of repo securities became standard market practice (for details, see 

Garbade, 2006). 

The foundation for the second important change in repo contracts was laid when 

another government securities dealer, Lombard-Wall, with $2 billion in assets and comparable 

liabilities, collapsed three months later in August 1982. Prior to Lombard-Wall’s August 12, 

1982, filing with the Federal Bankruptcy Court of New York, there had been no precedent court 

case in which the question of whether repos were secured loans or independent sale and 

repurchase agreements was directly addressed. If repos were classified as sale and repurchase 

agreements, then creditors could take immediate possession of the repo securities; if, on the 

other hand, they were classified as secured loans, then repo securities would have been subject 

to automatic stay. On August 17, 1982, the Federal Bankruptcy Court of New York announced 

that Lombard-Wall’s repos were secured loans and issued a restraining order prohibiting the 

sale of these repo securities. Although submissions by the Federal Reserve Bank of New York 

and several others argued that this decision would undermine the liquidity of the repo market, 

the court reaffirmed its decision a month later (Garbade, 2006). This removed the vagueness 

associated with whether repos were secured loans or independent sale and repurchase 

agreements. Despite this ruling, investment banks, mutual funds and other large financial 

institutions favored the exception of repo securities from the application of automatic stay, 
16

although they seemed unwilling to write contracts that clearly stated that a repo was a pair of 

outright sale and repurchase transactions.

13

Debates continued until another securities dealer, Lion Capital Group, collapsed in May 

1984, and a bankruptcy court placed an automatic stay on Lion’s repo securities.

14 Shortly 

thereafter, Congress ended the debates about the classification of repos by enacting the 

Bankruptcy Amendments and Federal Judgeship Act of 1984, exempting repos on Treasury and 

federal agency securities, as well as those on bank certificates of deposit and bankers’ 

acceptances, from the application of automatic stay. Since then, repos on these securities have 

been exempt from automatic stay.

Dealer delivery failures in the 1980s also gave rise to the emergence of “tri-party repos,” 

in which the counterparties used a third agent, called the tri-party agent, to manage the 

collateral. The tri-party agent ensured that the collateral pledged was sufficient and met 

eligibility requirements, and all parties agreed to use the collateral prices supplied by the triparty agent. Today, there are only two tri-party agents in the U.S., called the “tri-party clearing 

banks”: Bank of New York Mellon and JPMorgan Chase. Tri-party repos became popular partly

because of these efficiency gains associated with the intermediation role of the clearing banks. 

Indeed, the efficiency gains, and the fact that so many institutions use it, are among the 

reasons the Federal Reserve uses the tri-party repo market to implement monetary policy

(Copeland, Martin and Walker, 2010). However, because these two clearing banks have a huge 

amount of exposure on an intraday basis, regulators expressed concerns that fears of the 

financial health of a major dealer or clearing bank could quickly spread contagion throughout 

the market. Indeed, the Fed’s decision to extend its lender of last resort support to the 

systemically important primary dealers during the recent financial crisis through the so-called 

“Primary Dealer Credit Facility” (PDCF) was partly a result of these concerns.

The “tri-party settlement” is one of two settlement methods used in the U.S. The other 

is the “delivery versus payment” (DVP) method. For example, the Federal Reserve’s reverse 

repos are settled via the DVP method, wherein securities are moved against simultaneous 

payment. The Federal Reserve sends collateral to the clearing bank of its reverse repo 

counterparty, triggering a simultaneous movement of money against the collateral on the sale 

date. On the purchase date, the counterparty sends the collateral back to the Fed, which 

triggers the simultaneous return of the counterparty’s funds. Such repo transactions are called 

bilateral repo transactions. Dealers also use DVP repos to obtain funding. However, because 

DVP repos are not as convenient as tri-party repos, they are believed to represent a small share 

of dealer funding (Copeland, Martin and Walker, 2010). There is also the GCF repo market 

dealers use to exchange cash and general collateral with each other (Fleming and Garbade,

2003), as well as an interdealer repo market for less liquid collateral (Gorton and Metrick, 

2009). 

 

13 Even if they did, a court would be free to reclassify them.

14 “Lion Capital’s Collapse Raises Issue of Unresolved Legal Status of ‘Repos’”, Wall Street Journal, May 8, 1984.
17

Although the repo market grew rapidly after the Bankruptcy Amendments and Federal 

Judgeship Act of 1984, until the mid-1990s it remained confined mostly to U.S. government 

debt, federal agency debt, corporate debt, and federal agency mortgage-backed securities. 

However, since the mid-1990s, it has grown to include a broad range of debt instruments as 

collateral: all types of private-label MBS, such as residential mortgage-backed securities (RMBS) 

and commercial mortgage-backed securities (CMBS); all types of asset-backed securities (ABS), 

such as automobile loans, credit cards and student loans; and tranches of structured products 

such as collateralized mortgage obligations (CMOs), collateralized loan obligations (CLOs), 

collateralized debt obligations (CDOs), and the like (see Gorton, 2009a).

The last significant change to the repo contracting conventions came in 2005. In April 

2005, Congress enacted the Bankruptcy Abuse Prevention and Consumer Protection Act of 

2005 (BAPCPA), which took effect in October 2005. BAPCPA expanded the definition of 

repurchase agreements to include mortgage loans, mortgage-related securities, and interest 

from mortgage loans or mortgage-related securities. This meant that as of October 2005, repo 

contracts on even MBS, CMOs, CMBS, and CDOs backed by mortgages and the like as collateral, 

became exempt from automatic stay. We summarize the milestones in the evolution of the U.S. 

repo market in Box 1.

Furthermore, although repos collateralized by other financial securities such as 

corporate bonds, municipal loans and equities are excluded from the Bankruptcy Code 

definition of “repurchase agreements” and hence do not qualify for exemption from automatic 

stay for “repurchase agreements”, since they qualify as “securities contracts”, they are subject 

to safe harbor from automatic stay for the QFCs discussed in the previous section. To sum up, 

all transactions that fall under the umbrella of repos will likely be exempt from the automatic 

stay in bankruptcy either as "repos" or as "securities contracts" and therefore all repo 

transactions can be liquidated following a bankruptcy filing. 

No official statistics of the actual size of the repo market have been collected since 

inclusion of almost all types of securitized debt as collateral was allowed in repo agreements. 

Therefore, there is no official information on the evolution of the size of the repo market over 

the past quarter of a century. Figure 2 depicts the evolution of financing by primary dealers in

the U.S. government securities market from 1996 through 2011 and offers a feel for the 

exponential growth of the repo market since the mid-1990s. Meanwhile, Figure 3, reproduced 

from the FRBNY Task Force on Tri-Party Infrastructure White Paper (2010), show the growth of 

the tri-party repo market from May 2002 through May 2010.
18

III.2 Repo Market and the Crisis of 2007-09

The financial crisis of 2007-2009 was a crisis not only of the traditional banks, but also of 

the shadow banks.15 Unlike traditional banks, shadow banks did not have access to the safety 

nets designed to prevent wholesale runs on banks – 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 in this period, 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. Other important runs that occurred in this period were on mortgage lenders, 

asset-backed commercial paper (ABCP) programs, structured investment vehicles (SIVs), and 

money market funds.

When the housing market changed course in the first quarter of 2006, the subprime 

mortgage market began to deteriorate. The first casualty of the continued weakness in the 

housing market was in the form of the collapse of two highly levered Bear Stearns hedge funds 

that invested in subprime mortgages on June 20, 2007. The collapse of these two hedge funds 

was indeed a run on a shadow bank in the repo market. The two funds (one of which at its peak 

was levered ten times its equity) were speculating mostly in CDOs on subprime mortgages, 

borrowed funds in the repo market and pledged their CDOs as collateral. 

With the deterioration of the subprime market in the first half of 2007, creditors began 

asking the two Bear Stearns funds to post more collateral to back the repos by mid-June 2007. 

When the funds failed to meet these margin calls, creditors, led by Merrill Lynch, threatened to 

declare the funds in default of repo agreements and seize the investments. In fact, on June 19, 

2007, Merrill seized $850 million of the CDOs and tried to auction them. When Merrill was able 

to sell only about $100 million worth of CDOs, the illiquid nature and the declining value of 

subprime assets became evident. Bloomberg reported that at least seven other lenders, 

including Lehman Brothers and Deutsche Bank, also circulated lists of CDOs and other bonds 

that they were planning to sell. This shadow bank run and the systemic crisis that followed 

illustrate the significance of the exemption of repo securities from the application of automatic 

stay; had the repo securities been subject to automatic stay (or alternatives proposed below), 

the Bear Stearns funds could have filed for bankruptcy and the forced fire sale of their assets 

could have been avoided.

Eventually, the subprime mortgage decline became systemic. In early August 2007, a run 

ensued on the assets of three SIVs of BNP Paribas. On August 9, BNP Paribas suspended 

redemptions from these SIVs. BNP Paribas’s SIVs were bankruptcy-remote entities financing 

their subprime holdings through the issuance of ABCPs that had essentially lost their liquidity 

and became non-tradable. The announcement of the suspension of redemptions by BNP 

 

15 A shadow bank is a nonbank financial institution that behaves like a bank, borrows short-term in rollover debt 

markets, leverages itself significantly, and lends and invests in longer-term in illiquid assets. Unlike banks, however, 

the shadow banks are much less regulated (Acharya and Öncü, 2010).
19

Paribas gave rise to counterparty risk concerns and caused the ABCP market to freeze. This 

freeze coincided with the first major jump in the LIB-OIS spread. When fears of counterparty 

risk spread through markets, all short-term debt markets -- including the repo market -- froze, 

only to open after central banks injected massive amounts of liquidity into the system (see 

Acharya and Richardson, 2009). 

Based on a dataset obtained from dealer banks, Gorton and Metrick (2009) studied the 

repo spreads and haircuts for various types of repo securities. The spreads and the haircuts 

reported in their work are only for dealers; non-dealer counterparties may have been subject to 

other spreads and haircuts. The repo spreads are the spreads between the three-month repo 

and the three-month OIS rates. Their results demonstrate clearly how a crisis that started in the 

subprime market spread like a wildfire to other types of comparable non-transparent 

securitized debt, such as automobile, credit card and student loan asset-backed securities, as 

well as the high-credit-rated structured products, such as AAA- and AA-rated CLOs and CDOs. 

As Gorton and Metrick claim, the increasing haircuts in the interdealer repo market may 

be interpreted as a run on shadow banks. Figure 4, reproduced from Gorton and Metrick 

(2009b), shows how that run evolved. The data they examine are the interdealer repo haircuts 

for the following asset classes: (1) A-AAA Auto/Credit card/Student loan ABS; (2) AA-AAA 

RMBS/CMBS; (3) <A RMBS/CMBS; (4) AA-AAA CLOs; (5) Unpriced ABS/MBS/all subprime; (6) 

AA-AAA CDOs; (7) Unpriced CLOs/CDOs (where “unpriced” means that the collateral does not 

have public pricing on either Reuters or Bloomberg). Of these, the categories (1)–(4) do not 

contain subprime mortgages and are labeled “Non-Subprime-Related” by Gorton and Metrick. 

In particular, the RMBS referred to in categories (2) and (3) are prime mortgages. The 

categories (5)–(7) are either directly subprime or contain subprime mortgages. CDOs, in 

particular, contain some subprime mortgages. Finally, using all seven categories, they also 

construct an equal-weighted average repo haircut index for structured bonds.

As can be seen from Figure 4, the run on the shadow banking system in the interdealer 

repo market occurred in two phases. Although Bear Stearns’s hedge funds were the first 

victims, it was BNP Paribas’s suspension of redemptions on its three SIVs that triggered the first 

phase in August 2007. The failure of Bear Stearns in mid-March 2008 was the next phase of the 

run in the repo markets. It was not only the interdealer repo market for less liquid collateral 

that Gorton and Metrick (2009) studied where repo runs occurred. FRBNY White Paper (2010) 

states that “(a)t several points during the financial crisis of 2007-2009, the tri-party repo market 

took on particular importance in relation to the failures and near-failures of Countrywide 

Securities, Bear Stearns, and Lehman Brothers. The potential for the tri-party repo market to 

cease functioning, with impacts to securities firms, money market mutual funds, major banks 

involved in payment and settlements globally, and even to the liquidity of the U.S. Treasury and 

Agency securities, has been cited by policy makers as a key concern behind aggressive 

interventions to contain the financial crisis.” 
20

Consider for instance the “run” on Bear Stearns.16 As an intrinsic part of its business, 

Bear Stearns relied day-to-day on its ability to obtain short-term finance through secured 

borrowing. At this time, Bear was reported to be financing $85 billion of assets, primarily 

mortgage-backed securities (MBS), on the overnight market (Cohan, 2009). Beginning late 

Monday, March 10th, rumors spread about liquidity problems at Bear Stearns. Counterparties 

became unwilling to lend on customary terms. In particular, Federated and Fidelity – two 

money markets usually rolling over $5 billion each of repo financing to Bear – did not roll over. 

This unwillingness to fund on a secured basis placed enormous stress on the liquidity of Bear 

Stearns. On Tuesday, March 11, the holding company liquidity pool declined from $18.1 billion 

to $11.5 billion (see Figure 5). On Thursday, March 13, Bear Stearns' liquidity pool fell sharply 

and continued to fall on Friday. In the end, the fear of repo financiers that they would be left 

with highly illiquid MBS collateral to sell in the market led to a “run” and the near failure of the

firm and was eventually sold with assistance of the Federal Reserve to J P Morgan. In contrast 

to the smoothly rising haircuts in the bilateral repo market shown in Figure 4, financing terms 

for Bear Stearns in the tri-party repo system did not rise dramatically, but it experienced a 

sudden freeze or a “run” from some of its largest repo financiers who feared acquiring the 

underlying collateral and fire-selling it in an illiquid market.

After Bear Stearns collapsed in March 2008, the Fed introduced its most radical change

in monetary policy since the Great Depression by extending its lender of last resort support to 

the systemically important primary dealers through the new Primary Dealer Credit Facility 

(PDCF). However, even this extension of the lender of last resort facility did not prevent the run 

on Lehman Brothers, as investors realized that this support was not unconditional and 

unlimited (see Acharya et al, 2009).17

Indeed, using data collected by the FRBNY to document quantitative features of this 

market, Copeland, Martin and Walker (2010) studied the tri-party repo market and 

demonstrated that haircuts in the tri-party repo market barely moved during the crisis. They 

found that both the level of haircuts and the amount of funding were surprisingly stable in this 

market during the period from July 2008 to early 2010 for which they had data.18 Although the 

stability of the margins was in contrast to evidence from other repo markets, they provided 

evidence that “this apparent stability did not prevent the tri-party repo market from 

contributing to the problems experienced by Lehman Brothers, ... The available evidence 

suggests that runs in the tri-party repo market may occur precipitously, more like traditional 

bank runs, rather than manifest themselves in the form of large increases in margins.” Figure 6, 

 

16 The discussion that follows is based on the Securities and Exchange Commission press release on March 20, 

2008 entitled, “Chairman Cox Letter to the Basel Committee in Support of New Guidance on Liquidity 

Management,” available at: http://www.sec.gov/news/press/2008/2008-48.htm

17 While the largest haircut jump in Figure 4 corresponds to the collapse of Lehman on September 15, 2008, the 

second largest jump, which came in the summer of 2008, corresponds to traditional bank runs on likely insolvent 

banking institutions, such as IndyMac, Washington Mutual and Wachovia.

18 This finding is also corroborated in Krishnamurthy, Nagel and Orlov (2011), who also attribute the relative 

stability of the tri-party repo market to the substitute for repo funding provided by Fed-initiated liquidity facilities 

against illiquid collateral, especially following the collapse of Bear Stearns.
21

reproduced from Copeland, Martin and Walker (2010), provides a feel for the run on Lehman in 

the tri-party repo market they documented (see, Copeland, Martin and Walker, 2010, for 

details).

With the Lehman bankruptcy on September 15, 2008, the repo market on even U.S. 

government debt, federal agency debt, corporate debt and federal agency mortgage-backed 

securities came to a near halt, and settlement fails of primary dealers skyrocketed. Table 1 

shows a quarterly summary of the primary dealer settlement fails from the first quarter of 2007 

to the last quarter of 2009. Figure 7 provides a quarterly summary of the effects of the run on 

the repo market on the financing of primary dealers after Lehman’s collapse. As shown, it was 

the borrowing ability of the primary dealers that went down significantly, not their lending 

ability. Since this may be interpreted as large withdrawals from the broker-dealer shadow 

banks in the repo market, Figure 7 also illustrates the disappearing confidence in the shadow 

banking system and the severity of the run on shadow banks. When the Fed and the U.S. 

government let Lehman collapse, the next in line for a run, Merrill Lynch, had to merge with 

Bank of America. Shortly thereafter, the two remaining independent broker-dealers, Morgan 

Stanley and Goldman Sachs, were forced to convert to bank holding companies and were 

formally put under supervision and regulation of the Federal Reserve. In fact, the entire Wall 

Street system of independent broker-dealers collapsed in a matter of seven months (see 

Acharya et al, 2009).

III.3 A Case for Reforming the Repo Market

As Acharya and Krishnamurthy (2010) clarify, the primary issue with financing risky 

securities (such as mortgage-backed securities) through repo markets is that such financing is 

likely to freeze or experience stress in times of aggregate (economy- or financial sector-wide) 

stress, and on their own, financial firms do not have the incentive to internalize the costs of 

such a freeze or stress. By virtue of being secured and typically short-term financing 

arrangements, repo markets, by and large, function smoothly; in other words, repos usually get 

rolled over. When the underlying assets, such as Treasury or agency debt, are essentially safe, 

the repo financier is undeterred from rolling over the financing even in stressful times. Indeed, 

Treasury and agency debt might even experience a flight to safety in such times. 

In contrast, if the underlying collateral is a mortgage-backed security and an economic 

downturn ensues, the risk of an already illiquid market for MBS gets compounded; this is 

because many financial institutions’ portfolios are crowded with MBS or have lost capital. In 

this scenario, repo financiers run the real risk of being forced to sell their collateral in illiquid 

markets. The repo financier may respond by raising the required haircut or simply refusing to 

roll over. The resulting fall in repo financing ability against the collateral is perverse, as it sets up 

an adverse dynamic: The future buyers of assets anticipate that they are likely to face steep 

haircuts too and thus will not offer attractive prices for assets; in turn, the collateral’s ability to 

be financed with repo today falls even further. A complete market freeze can arise as it did 
22

during the crisis of 2007-2009. Indeed, in his analysis of the failure of Bear Stearns, the Federal 

Reserve Chairman Ben Bernanke observed:19

“*U+ntil recently, short-term repos had always been regarded as virtually risk-free 

instruments and thus largely immune to the type of rollover or withdrawal risks associated with 

short-term unsecured obligations. In March, rapidly unfolding events demonstrated that even 

repo markets could be severely disrupted when investors believe they might need to sell the 

underlying collateral in illiquid markets. Such forced asset sales can set up a particularly adverse 

dynamic, in which further substantial price declines fan investor concerns about counterparty 

credit risk, which then feed back in the form of intensifying funding pressures... *F+uture liquidity 

planning will have to take into account the possibility of a sudden loss of substantial amounts of 

secured financing.”

To summarize, unlike the liquidity risk that unsecured financing may become 

unavailable to a firm (a risk largely specific to the credit risk of the firm), the liquidity risk that 

secured repo financing may become unavailable to a firm is inherently a systemic risk, 

materializing in circumstances where other financial firms are also experiencing stress and the 

markets for assets held predominantly by the financial sector are rendered illiquid. This leads to 

the problem that while in good times, financial firms may not fully internalize the costs imposed 

on the system by being excessively financed through short-term repo markets, in bad times, 

they charge excessively high haircuts on repo financing and do not internalize the pecuniary 

externalities imposed on other firms through the resulting fire sales of assets. Indeed, to 

support financial firms facing a repo freeze or to support the assets directly, the likely lender of 

last resort would only accentuate a problem that firms ignore in good times -- namely, the 

systemic risk associated with repo financing. Viewed this way, in good times, there is a case for 

subjecting repo-financed risky securities to a capital charge -- effectively a regulatory haircut --

which takes into account the security’s systemic risk and maturity mismatch relative to the repo 

tenor. Equally important, there is a case for a better design of the bankruptcy of a repofinanced debtor than simply granting its repo financier the full right to seize the collateral and 

liquidate it at will in an illiquid market. 

IV. Proposal for a Repo Resolution Authority

Although the DFA is completely silent about how to reform it, at least two attempts 

have been made to address weaknesses inherent in the repo market. The first of these 

attempts was made by the Committee on Payment and Settlement Systems (CPSS) of the Basel 

Committee on Banking Supervision, which undertakes specific studies in the field of payment 

and settlement systems. The CPSS commissioned a working group on repo market 

infrastructure “to investigate the extent to which the clearing and settlement infrastructure for 

 

19 The quotes are based on Ben Bernanke's remarks to the Risk Transfer Mechanisms and Financial Stability 

Workshop at the Bank for International Settlements, May 29, 2008.
23

repos contributed to the instability evident in some repo markets” in June, 2009.20 After a 

comprehensive survey of the clearing and settlement arrangements for repos in selected CPSS 

member countries, the working group published their report in September, 2010.

21 Their

conclusion was that it was worthwhile for the stakeholders in each market to review how the 

clearing and settlement arrangements for repos could be further strengthened.

The second of these attempts was made by the Tri-Party Repo Infrastructure Reform 

Task Force (“Task Force”) which was formed “to address weaknesses that became visible over 

the course of the recent financial crisis” in September, 2009, under the auspices of the 

Payments Risk Committee, a private sector body sponsored by the Federal Reserve Bank of 

New York.22 The Task Force published its final report with recommendations to strengthen the 

infrastructure supporting the tri-party repo market in May, 2010.23 The July 6, 2011, progress 

report of the Task Force indicated that although progress had been made in regards to 

implementing the reforms recommended in May, 2010, they were behind the schedule and 

continuing to develop the remaining steps to achieve their objectives.

24 The focus of the Task 

Force had primarily been on the issue of whether JPMorgan Chase and Bank of New York, the 

tri-party brokers, extend credit risk intra-day, how that risk could be mitigated or adequately 

capitalized, and other intra-day infrastructure issues. The Task Force released its final report on 

February 15, 2012 and reported that despite significant accomplishments, their ultimate goal of 

the “practical elimination” of intra-day credit extension by the clearing banks was years away. 

Consequently, the Fed decided to explore additional policy options, including limitations on 

eligible collateral and a “facility to foster the orderly liquidation of collateral in the event of a 

dealer’s default” (see, Tuckman, 2012 for details).25

On balance, the macro-prudential issue of containing bank-style runs in the repo 

markets and the risk of fire-sale liquidations of illiquid collateral such as mortgage-backed 

securities has not been discussed substantially. On this macro-prudential issue, possible 

reforms of the repo market can be put into three categories:

1) a full government-guarantee scheme for repo market liabilities; 

2) a full market-discipline scheme in which repo liabilities are not exempt from 

bankruptcy but subject to automatic stay as with secured borrowing contracts of 

non-financial firms; and,

3) a combination of the two. As we explain below, our preferred alternative is the 

combination but where guarantee extended is in the form of a temporary liquidity 

guarantee and its potential moral hazard consequences are controlled for.

 

20 http://www.bis.org/cpss/index.htm

21 http://www.bis.org/publ/cpss91.htm

22 http://www.newyorkfed.org/tripartyrepo/

23 http://www.newyorkfed.org/banking/nyfrb_triparty_whitepaper.pdf

24 http://www.newyorkfed.org/tripartyrepo/pdf/PR_110706.pdf

25 Interestingly, “limitations on eligible collateral and a facility to foster the orderly liquidation of collateral” were 

among the policy suggestions we also had made in an earlier work (see, Archarya and Öncü, 2010).
24

At one extreme, some (most notably, Gorton, 2009) have suggested that repo financing 

is akin to demandable deposits in many ways and thus is similarly vulnerable to the 

information-sensitive panics when adverse information about underlying collateral (or 

counterparties) hits markets. His proposal is thus to treat repo financing in a similar way – that 

is, offer federal deposit insurance to the repo contracts, at least against securities that are 

relatively “safe,” such as the super-senior tranches of securitization pools and “deposits” 

(technically savings) with the money market funds. Under this proposal, it is recognized that 

repo financing has the inherent systemic fragility akin to demandable deposits, and in all 

likelihood, the government would end up backing up repo counterparties were the fragility to 

materialize. Hence, by explicitly recognizing the guarantee upfront, it becomes possible to 

charge repo financiers for the guarantee. As with any insurance premium, the objective is not 

just only to collect fees for an ex post guarantee, but also to get repo financiers to internalize 

the systemic fragility inherent in repo contracts. 

At another extreme, others (most notably, Roe, 2009 and Perotti, 2010) have proposed 

that repo financiers should not be allowed unrestricted access to collateral even in case of 

default of the counterparty. That is, there should be some sort of “automatic stay” on repo 

financiers’ claims, and they should join the bankruptcy of the defaulting counterparty as a 

secured creditor, as in the case of corporate bankruptcies. The rationale for this is twofold: first, 

it prevents the systemic liquidity risk due to fire sales of the repo collateral by the financiers 

and avoids the adverse dynamic we highlighted before; and second, by exposing the repo 

financiers to credit risk of the counterparty (and not just that of the collateral), the financiers 

would subject the borrowers to much greater market discipline. In particular, financiers would 

opt for safer counterparties, all else being equal, or charge higher haircuts to riskier ones --

either way, discriminating ex ante between safer and riskier borrowers.

The advantage of the government guarantee scheme is that it resolves virtually all ex 

post uncertainty by transferring the risk of repo contracts away from financiers to the 

government agency for an upfront fee. However, its disadvantages are more subtle and 

somewhat pernicious. The charging of FDIC premiums has been heavily influenced by the 

banking industry, and no premiums have historically been charged to most banks when the 

FDIC’s reserve fund is capitalized above 1.25% to 1.35% of the insured deposits. This kind of a 

fee structure gives rise to a highly pro-cyclical risk-taking incentive, because, as far as the riskreturn tradeoff is concerned, the risks are back-loaded. There is no guarantee that repo 

insurance premiums would work any differently. Perhaps, and somewhat more disturbingly, 

such a guarantee scheme effectively amounts to transferring the credit risk of virtually most 

parts of the securitization market to the government’s balance sheet. While “conforming” 

mortgages in the U.S. are already being backstopped by Fannie Mae and Freddie Mac, the 

proposed guarantee scheme would extend such a backstop to subprime securitized pools, 

corporate loans, automobile receivables, credit-card receivables, and so on. Due to its potential 

sovereign risk concerns in an environment of difficult fiscal position for the government, the 

idea of extending guarantees to practically all financial assets of the economy should be viewed 

with caution. Such caution would be even more necessary for governments other than the U.S. 

whose balance sheets are already heavily stretched.
25

On the other hand, the advantage of market discipline through the automatic stay 

approach is that it transfers the entire risk of the repo transaction to the repo financier – to 

some extent the risk of the collateral but also that of the borrower’s ability to pay. This way, 

other than through ex post forbearance, private markets are allowed to function – bear and 

price risks – and thereby provide incentives to take account of relevant risk-return tradeoffs. 

There are, however, several countervailing issues that arise. First, since the primary issue with 

repo contracts is their systemic externality, it is unclear that private market outcomes would be 

necessarily efficient from a risk-return standpoint of the economy as a whole. Second, 

automatic stay introduces “basis risk” in the repo contract, since its eventual payoff is linked 

not just to the underlying asset but to the whole pool of assets of the borrower and the rest of 

its capital structure. In general, this may create sufficient ex ante, as well as ex post, uncertainty 

to reduce the financier’s willingness to lend against certain assets to all types of borrowers. The 

result might be a significant reduction in ex ante liquidity in some parts of repo-financed 

securitized markets. Third, a rationale for the bankruptcy exemption of the repos has been that 

when the borrower defaults, counterparty risk transmission is reduced as far as the repo 

contract goes because it is protected from any spillover of the borrower’s remaining risks and 

liabilities. 

Given this relative assessment, our preferred approach is one that facilitates a ready 

winding down of the repo contracts as far as reasonable liquidity for repo financiers is 

concerned and at the same time eliminates disorderly fire sales of underlying assets. In

particular, the approach consists of setting up a Repo Resolution Authority that meets the 

criteria 1)-5) we laid out in the Introduction for resolution of SIALs. In case of default of a repo 

counterparty (the borrower), the repo resolution authority would ensure orderly resolution of 

its repo liabilities and also an orderly liquidation of the underlying collateral; in good times, the 

repo resolution authority would ensure that the services it provides at time of default are not 

contributing to excessive risk of defaults in the repo markets.

Specifically, instituting the repo resolution authority requires the following pieces:

1) In case of default of a borrower, its repo counterparties on Treasuries, and perhaps 

agency-backed securities (assuming the agency-backed securities are effectively 

government backed), are “exempt from stay” and counterparties are allowed to take 

their collateral as under the current arrangements. 

2) However, repo counterparties on risky collateral, such as ABS and MBS, are 

subjected to a “stay” as with secured borrowing of non-financial firms.

3) Immediately upon default, repo financiers of risky collateral are paid by a “repo 

resolution fund,” a recovery amount that is based on a conservative value 

assessment of the collateral.26 Such a value assessment could be based on market 

intelligence, historical estimates, projected valuations obtained from a poll of 

 

26 The repo resolution fund could be dedicated to the repo resolution authority, or it is conceivable that it could 

simply be within the FDIC or the Federal Reserve. The fund should potentially be eligible for participating in the 

lender of last resort facilities of the central bank. If such participation is not clear a priori, uncertainty concerning it 

could lead to breakdown of our proposed resolution plan.
26

dealers, etc. The important issue is that the assessment should be “conservative”

and reflect reasonable haircuts that an asset liquidator would expect to incur when 

faced with asset liquidations. In particular, the conservative value could be 

dependent on the total size of repo liabilities of a borrower and/or on the total size 

of liabilities against a given type of collateral. The conservative recovery amount (or 

it schedule) should, however, be pre-determined and known to market participants.

4) In case of default on repo backed by risky collateral, the underlying repo collateral is 

taken over by the repo resolution authority and liquidated in an orderly manner 

over a pre-specified period, say, not more than six months (but with some flexibility 

to deal with unexpected circumstances). 

a) If the eventual recovery on the collateral is greater than the conservative 

estimate paid to the repo financiers (see step 3) above), then the timevalue adjusted difference is paid eventually to the repo financiers. 

b) Conversely, if the eventual recovery is lower than the conservative 

estimate paid to the repo financiers, the time-value adjusted difference is 

“clawed back” from the repo financiers. The claw-back feature would 

have to be explicitly legislated (as with the current mechanism used by 

FDIC to deal with uninsured depositors of failed FDIC-regulated banks).

5) In effect, steps 3) and 4) resemble a lender of last resort (LOLR) operation, whereby 

risky collateral in times of a systemic crisis would be provided liquidity, albeit 

conservatively at a “haircut” or penalty rate. The operation is of the LOLR flavor 

since it suspends immediate conversion to currency for repo financiers in the form 

of collateral liquidations and replaces it with an upfront but conservative payment 

by repo resolution fund at time of default, with rights to liquidation conferred upon 

the repo resolution authority and not on repo financiers.

6) In case of an isolated default in the repo market, that is, default in a time when the 

underlying collateral market is reasonably liquid, the collateral liquidation by the 

repo resolution authority would be relatively swift, at close to fundamental or liquid 

collateral values, and effectively the repo financiers will be repaid conservative 

amount plus the additional recovery within a few days. That is, in this case, an 

effective automatic stay on repo contracts would be just a couple of days.

7) However, in case of clustered defaults of several counterparties in the repo market, 

e.g., because there is an aggregate shock such as a significant housing price decline 

or because the market for housing-related assets is weak due to overhang of other 

financial firms from holdings of similar assets, the collateral liquidation by the repo 

resolution authority could take time, and not generate liquidation proceeds that are 

up to the conservative recovery payment made to repo financiers. This implies that 

a) The effective automatic stay on repo contracts would be more 

substantive, but in economic terms not as substantive as the asset 
27

liquidation period due to the conservative early payment made by the 

repo resolution fund.

b) Importantly, the claw-back feature would come in to play and repo 

financiers could be required in part to return the liquidity provided by the 

repo resolution fund (when the time-adjusted eventual recovery is lower 

than the conservative recovery payment made at the time of default).

8) The claw-back possibility in 7b) above implies that the repo resolution authority 

takes on the credit risk of repo financiers, as well as of the underlying collateral. 

This credit risk is limited to the difference between realized recovery and the 

conservative estimate at the time of the borrower’s bankruptcy, and linked to 

the credit quality of the repo financier. In particular, if the repo financier defaults 

in the period when the repo resolution authority is liquidating the underlying 

collateral, then repo resolution authority effectively becomes a creditor of the 

repo financier and may face losses in case of repo financier’s default. To manage 

this credit risk, the repo resolution authority should do the following:

a) Include as eligible only relatively high-quality collateral, that is, certain 

highly risky securities such as pools backed by low-quality mortgages may 

be excluded from repo resolution authority altogether and repos with 

them as underlying collateral subject to the usual automatic stay as in 

case of secured borrowing by non-financial firms;

b) charge repo financiers an ex ante fee for the lender of last resort or 

conservative liquidity payment facility, commensurate with the residual 

credit risk borne by the facility, in order to provide a financing for the 

repo resolution fund;

c) require that eligible repo financiers for the lender of last resort facility

provided by the repo resolution authority meet pre-specified solvency 

criteria (which should be based on a range of solvency metrics, including 

market capitalization and funding capacity, rather than just easily 

arbitraged and static risk-weight style rules on book value of equity); and

d) impose a concentration limit at the level of individual repo financiers, as 

well as on the financier’s overall portfolio size, recognizing that controls 

in a)-c) above may mitigate credit risk borne by the repo resolution 

authority but not eliminate it altogether.

Thus, our preferred approach in the form of a repo resolution authority provides ex post

liquidity to the repo market rather than a complete guarantee of underlying risks. This 

approach also charges ex ante for this liquidity facility and ensures that the risks undertaken by 
28

the market participants do not expose the taxpayers to losses beyond a certain size. That is, it 

makes an effort not to take on solvency risk while trying to address liquidity risk of repo 

markets. It combines the attractive features of full insurance and full market-discipline 

schemes, avoiding their weaknesses. Furthermore, in contrast to FDIC’s recent proposal of a 

fixed haircut for all repo collateral, it allows the haircut to be determined differentially for 

different collateral classes and sub-classes based on conservative value assessments at the time 

of the borrower’s bankruptcy. As highlighted in the Introduction, it attempts to address the 

systemic risks of both the repo runs and the market for underlying collateral, while containing 

the ex-ante risks created in the first place, and in a manner that can be harmonized 

internationally in a ready manner provided the various criteria in the scheme 1)-8) above are 

agreed upon by large repo centers of the world, or at least that they all meet some minimum 

reasonable standards.

Our proposal has similarities to the approach to regulation shadow banking laid out in 

Gorton and Metrick (2010). Specifically, the idea of limiting access to the safe harbor or 

bankruptcy exemption clauses for specific types of collateral-backed repos is also a part of 

Gorton-Metrick approach. However, there are also differences. The Gorton-Metrick approach 

recommends government guarantee scheme, akin to deposit insurance, for liabilities of moneymarket funds, whereas under our approach, once money market funds are subject to strict 

guidelines in repo market financing (and similarly in other SIALs), they would effectively be 

subject to solvency criteria similar to those for banks (and might not survive competition from 

banks in the first place). Further, while the primary risk-control in Gorton-Metrick scheme is 

through restriction of eligible collateral for safe harbor provisions, safe harbor is in principle 

eliminated from our repo resolution authority and it just conditionally happens to be akin to 

safe harbor in some cases even for eligible collateral (when defaults are isolated as in 6) above). 

It is also important to discuss what would happen to repo contracts on collateral that is 

not eligible under the repo resolution authority and its strict guidelines and requirements. This 

would constitute the hypothetical “shadow banking” in a world of repo resolution authorities. 

These repo contracts would not have access to safe harbor and would be perceived as ex-ante 

riskier and of lower liquidity by financiers. However, this would not necessarily guarantee that 

financiers internalize the externalities of runs in the shadow banking. To guard against this, the 

repo resolution authority should on a periodic basis assess if a class of repo claims has become 

large enough and the underlying collateral is suitable quality enough to be eligible for repo 

resolution authority’s LOLR. If yes, they should be required by legislation to be moved out of 

shadow banking into the repo resolution authority. And, where the underlying collateral is not 

of adequate quality or repo contract class sufficiently small in size, a minimum haircut (or 

overcollateralization) requirement should be imposed, akin to FDIC’s proposed haircut on all 

repos or a more risk-sensitive scheme such as bank capital requirements. Ideally, the haircut 

scheme should be counter-cyclical and certainly not pro-cyclical (that is, not provide too low or 

non-existent haircuts in good times, such as on MBS with low quality mortgages or government 

bond repos where government credit risk is non-trivial as in the Eurozone since 2008).
29

V. A Historical Precedent: The Glass Proposal

As Graeber (2011), and Reinhart and Rogoff (2009) documented, banking crises have 

been ubiquitous throughout recent history and one common problem to almost all has been 

the loss of liquidity to bank depositors. In the wake of one of these crises, namely, the banking 

panic of 1907, the National Monetary Commission of the U.S. - established by the Congress in 

the Aldrich-Vreeland Act of 1908 – prepared a 19-question questionnaire and mailed to various 

representatives of the U.S. banking industry (Kaufman, 2004). One of the questions – the 18th–

asked:27

“Would it be well, in your opinion, to change the existing laws so that liquidating banks 

could, in some way, arrange to pay depositors more rapidly? A careful examination of 

the assets of failed banks will show about how much dividend they can eventually pay, 

and considerable distress would be prevented if something approximating this amount 

could be paid to depositors without any delay.”

As Kaufman (2004) reports, “(r)esponses were obtained from 85 respondents. Of these, 63, or 

some two-thirds, favored a change to pay depositors of closed banks more rapidly. This percent 

was the same among bankers and bank examiners, the two largest groups of respondents. Only 

12 respondents, or 14% were opposed to such a change and the remainder either skipped the 

question or were undecided.”

As we mentioned in the opening of Section II, a central objective of the DFA is to create 

a new resolution mechanism for nonbank SIFIs and bring them within the FDIC insurance 

model. In the wake of the next banking crisis after the panic of 1907, namely, in the early years 

of the Great Depression of 1929 and before the establishment of the FDIC in 1933, Senator 

Carter Glass – the then chairman of the Senate Banking Committee and a coauthor of the 

Federal Reserve Act of 1933 – proposed more rapid payment to depositors at failed banks as a 

superior alternative to deposit insurance, which he opposed (Kaufman, 2004). As quoted by 

Kaufman (2004), Willis and Chapman (1934, pp. 65-67) describe the objective of the Glass 

proposal as follows:

“Recognizing that in bank failures the source of difficulty and loss is not primarily found 

in lack of assets, but ... that the resources of depositors are tied up and rendered 

unavailable for long periods ... liquidation power and not guaranty was demanded ...

insuring an almost immediate settlement within a short time upon the basis of the 

estimated worth of the *failed+ bank’s assets ... This plan was considered by the 

[Banking] Committee entirely adequate to the protection of the bank depositor against 

most of the evils to which he had been subject, while leaving him still with a measure of 

individual responsibility for the protection of his claims through the selection of a wellqualified bank.”

The Glass proposal called for the establishment of a Federal Government Liquidating 

Corporation (FGLC) to estimate a bank’s recovery value immediately upon its failure, quickly sell 

 

27 As quoted by Kaufman (2004), p. 243 
30

the bank as a whole or in parts, and quickly pay the proceeds to the receiver for speedy 

disbursement to the depositors (Kaufman, 2004). Despite the differences, the similarities 

between our repo resolution proposal and the proposal of Senator Glass are astounding. 

Although we do not promote quickly selling the “repo banks” as a whole or in parts – except 

their highly liquid repo collaterals such as Treasuries, and perhaps agency-backed securities –

for reasons we have argued at length, we also call for a liquidating agency (our repo resolution 

authority) to “estimate a (repo) bank’s recovery value immediately upon its failure, ... and 

quickly pay ... the receiver for speedy disbursement to the depositors (repo financiers).” In the 

first regard, our repo resolution authority resembles the Orderly Liquidation Authority of the 

Dodd-Frank Act more than the Federal Government Liquidating Corporation that Senator Glass 

proposed, since we are concerned also with the orderly liquidation of potentially illiquid and 

risky repo collaterals such as the MBSs. In the second regard, our repo resolution authority

resembles the FGLC of the Glass proposal more than the OLA of the Dodd-Frank Act because of 

our call for paying the repo financiers of risky repo collaterals a recovery amount that is based 

on a conservative value assessment of the collateral by a “repo resolution fund.”

In the end, the Glass proposal was found too difficult to implement, primarily because 

many believed that it required more accurate estimates of the market value of the failed bank’s 

assets than possible at the time (Kaufman, 2004). This is another similarity between our 

proposal and the Glass proposal. Many may argue that our proposal requires more accurate 

estimates of the market value of the risky and illiquid repo collaterals than possible at our time. 

Yet, the advantages of the scheme proposed by Senator Glass had also been seen by others. 

For example, although it did not become operational, the Federal Reserve Bank of New 

York attempted to have depositors at failed banks receive the recovery value of their claims 

faster by requesting healthy member banks to buy the assets of failed banks and advance the 

proceeds to them for immediate distribution in 1931 (again see, Kaufman, 2004, and the 

references therein). And, in 1933, the New York State Banking Department was able to 

implement such an arrangement when it entered into agreements with Manufacturers Trust 

Co. and other large New York City commercial banks to serve as both liquidating and paying 

agents for a failed bank and partially assume the deposits of the bank up to an agreed 

percentage of paramount (Upham and Lamke, 1934). As quoted by Kaufman (2004), Charles 

Clough, comptroller of Manufacturers Trust, noted the advantages of this program as follows:

“Three things were definitely accomplished. Business men, whose working capital was 

frozen, were given relief through the release of their bank balances, and at the same 

time, were given immediate substantial banking connections which would enable them 

to continue in business; apparent distress among depositors was relieved at once; and 

the entire process of liquidation was accomplished more expeditiously and economically 

than was thought possible.”

Another example, which is also an important precedent that relates to our proposal for 

a repo resolution authority and inspired by the Glass proposal, is the Reconstruction Finance 
31

Corporation (RFC). The RFC was established by the Reconstruction Finance Corporation Act in 

1932 and authorized to loan funds to banks closed for liquidation or reorganization to enable 

them to make quick partial payments to depositors. As Kaufman (2004) quotes from Jesse 

Jones, long-time chairman of the RFC, these loans – securitized by the failed banks' assets –

would 

“...make at least a part of the depositor's balance available to him, pending 

liquidation....We endeavored to lend up to the probable liquidation value of their *the 

bank's+ assets...The government could afford to wait; often the individual could not.”

The reason for the establishment of the RFC was that “(f)reezing deposits at these banks 

was viewed as decreasing purchasing power in the community and delaying recovery from the 

Depression (Kaufman (2004).” Indeed, to avoid decreased purchasing power in the community 

and delayed recovery from the Depression, President Franklin Roosevelt suggested a deposit 

liquidation program "to stimulate and encourage liquidating agents of banks closed after 

January 1, 1933 to borrow funds from the RFC in order that funds may be made available to 

depositors as quickly as possible" (Upham and Lamke, 1934, pp. 168-69). 

However, the RFC did not agree to operate in the suggested program directly. For this 

and other reasons, Roosevelt established a new liquidation board, i.e., the Deposit Liquidation 

Board (DLB) to lend to the failed banks. The DLB could borrow from the RFC using the assets of 

the failed banks as collateral, but it charged the banks a lower interest rate on the loans than 

the rate charged by the RFC (Kaufman, 2004). The DLB loaned on 80% of the liquidation value of 

the assets, but this liquidation value was determined not on the basis of the current book value 

of the failed bank’s assets but on values that the RFC projected it could get in "an orderly 

liquidation period of three to five years in a recovering stock and bond market" (Olson, 1988, p. 

75).

Although the volume of loans provided by the DLB increased rapidly in 1933, it was still 

considered by some as too little and too slow. A number of bills were introduced in Congress to 

have the Treasury or other federal agencies also advance funds to depositors at closed banks, 

but, despite gathering considerable support, none of the bills were enacted (Calomiris and 

White, 1994). Kaufman (2004) notes that “(a)uthority to provide such loans was, however, 

included in the Federal Deposit Insurance Act, although apparently not used to liquefy frozen 

uninsured deposits until 50 years later in 1983. With the sharp decline in the number of bank 

failures after 1934, legislative interest in liquefying deposits at failed banks diminished.”

VI. Concluding Remarks 

Regulators and policymakers in the U.S. and abroad have made rough sketches of 

proposals that would avoid bankruptcy proceedings for systemically important financial 

institutions (SIFIs). One idea is that there should be provision of “contingent capital” or “co-co 

bonds”, a (small) part of SIFI’s liabilities that would convert to equity mechanically based on a 
32

firm-specific and/or system-specific trigger. Such conversion would provide the SIFI with some 

debt relief and thus some extra time to deal with its problems. A related idea is that of a “bail 

in” under which a SIFI’s deterioration past a specified benchmark would trigger for some claims 

a pre-specified haircut or the elimination of some claims entirely, effectively writing down 

firm’s liabilities to a predetermined extent. Bail-ins in particular are attractive if they can be 

enacted as part of an integrated capital structure, wherein SILs (such as swap agreements) are 

placed in high-priority tranches while ordinary bonds and equity are left to suffer conversion or 

elimination in the event that the firm would be unable to pay all of its obligations. Such a 

capital structure, enacted perhaps as part of a SIFI’s living will – a plan of resolution required for 

the U.S. firms by the DFA – could lend stability by providing certainty about where losses would 

rest in the event of a financial crisis.

What we propose, based on the insights of Acharya, Adler and Richardson (2011), is that 

“top down” (or institution-level) approaches such as contingent capital, bail-in, or living wills, be 

built on top of a “bottom up” approach – one that works at the level of the SIALs rather than at 

the level of the SIFI that owns them. Under the bottom-up approach there would be an 

automatic stabilizer built into each systemically significant part of an SIFI’s capital structure. The 

automatic stabilizers could be in the form of government-provided but appropriately-charged 

deposit insurance, centrally cleared SIALs with initial and variation margins or haircuts charged 

by a clearinghouse or dedicated resolution authority for those SIALs, and in extreme cases, 

lender-of-last-resort from the central bank against eligible assets (but to avoid moral hazard, 

only to firms that pay a market-rate fee). A particularly attractive feature of this “bottom up” 

approach is that it requires no uniform institution-level insolvency process and therefore might 

be the simplest way of achieving international agreement on resolving the financial distress of 

G-SIFIs (as long as there is global agreement on resolution mechanisms for SIALs).

As an illustration of why such a bottom-up approach is needed, we note that the current 

financial legislation proposals are completely silent on how to reform the repo market in which 

financial firms borrow secured at a short-term maturity with rights for repo financiers in cases 

of most underlying collateral to be exempt from bankruptcy and liquidate the collateral in case 

of borrower’s default. We believe this omission is a mistake in light of the systemic nature of 

the repo market and its structural weaknesses. As we mentioned, unlike the liquidity risk that 

unsecured financing may become unavailable to a firm, the liquidity risk that secured repo 

financing may become unavailable to a firm is inherently a systemic risk: The markets for the 

repo securities may become illiquid precisely when a large part of the financial sector is 

experiencing undercapitalization or funding stress. 

Unless this systemic liquidity risk of repo market is resolved, the risk of a run on the 

repo market will remain. Our proposed solution is to set up a “Repo Resolution Authority” that 

maintains liquidity for repo markets in case of defaults, takes on the role of orderly liquidation 

of collateral, but controls its credit risk through ex-ante restrictions on qualifying collateral, 

qualifying repo financiers, concentration limits and minimum haircuts. Such a resolution 

mechanism addresses the externality of systemic risk of repo contracts on risky and potentially 
33

illiquid collaterals. And, such a mechanism can be exercised without overly compromising 

market discipline, market liquidity or taxpayer funds. 

Finally, although we have focused on the U.S. repo markets, our discussion and 

proposed reforms apply to other countries as well. Repo markets exist around the globe, from 

China to Japan to Hungary to Turkey, to name but a few countries, although their histories are 

much shorter and their sizes much smaller than that of the U.S. repo market. Many emerging 

countries’ repo markets date back to the early 1990s. The largest repo market outside the U.S. 

is the European repo market, which was established with the introduction of the Euro in 1999 

and stood at €5.6 trillion based on the amount outstanding on December 9, 2009 (according to 

the survey conducted by the International Capital Market Association with 53 financial 

institutions located in 14 European countries, as well as the U.S. and Japan). The European 

market is the only repo market outside the U.S. where potentially illiquid financial assets are 

used as repo collateral, and therefore our proposed reforms are also relevant to the European 

repo market. In other repo markets, the repo collateral generally represents government bonds 

issued by the sovereign states, so that in these markets, the repo financiers do not appear to 

run a substantial risk of being forced to sell their collateral in illiquid markets in the event of 

financial crises. This may change however, if potentially illiquid collateral were to become 

acceptable in repo transactions in these countries. Indeed, when sovereign credit risk is an 

issue, even the repo markets for government bonds may be vulnerable.

At any rate, leaving the repo markets out of the discussion of financial reforms is not an 

alternative; if these markets are not reformed and their participants not made to internalize the 

risk that large quantities of underlying repo collateral could be put up for liquidation in an 

illiquid market, then runs on the repo market will occur in the future, potentially leading to new 

systemic crises, in spite of the huge regulatory apparatus being built around financial firms on 

other fronts and markets.

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36

Figure 1: Monthly Averages of Daily Outstanding Overnight and Term Repos, 1970-86

Source: Federal Reserve Board

0

20

40

60

80

100

120

140

1970 1972 1974 1976 1978 1980 1982 1984 1986 Billions of Dollars
37

Figure 2: Annual Averages of Daily Financing by U.S. Government Securities Primary Dealers

Source: Securities Industry and Financial Markets Association.

0

1

2

3

4

5

6

7

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Trillions of Dollars

Reverse Repo

Repo
38

Figure 3: Growth of Tri-Party Repo Market

Source: FRBNY Task Force On Tri-Party Infrastructure White Paper (2010).

Trillions of dollars, monthly average

0.0

0.5

1.0

1.5

2.0

2.5

3.0

May-02

Nov-02

May-03

Nov-03

May-04

Nov-04

May-05

Nov-05

May-06

Nov-06

May-07

Nov-07

May-08

Nov-08

May-09

Nov-09

May-10

Nov-10
39

Figure 4: Repo Haircuts on Different Categories of Structured Products

Source: Reproduced from Gorton and Metrick (2009-b).
40

Figure 5: Bear Stearns’ liquidity pool just before its near failure

Source: SEC Chairman Christopher Cox’s letter to Basel Committee in support of New Guidance 

on Liquidity Management, available at: http://www.sec.gov/news/press/2008/2008-48.htm
41

Figure 6: Lehman Brother’s Tri-Party Repo Book by Collateral Type

Source: Copeland, Martin and Walker (2010)
42

Figure 7: Quarterly Averages of Daily Financing by U.S. Government Securities Primary 

Dealers, 2006-2011

Source: Securities Industry and Financial Markets Association.

0

1

2

3

4

5

6

7

8

2006-Q1 2007-Q1 2008-Q1 2009-Q1 2010-Q1 2011-Q1

Trillions of Dollars

Reverse Repo

Repo
43

Table 1: Settlement Fails of U.S. Government Securities Primary Dealers during the Crisis, 2007-

2009 ($ Billions)

Treasury Agency MBS Corporate

Receive Deliver Receive Deliver Receive Deliver Receive Deliver

2007

Q1 738.1 586.8 91.2 76.6 474.6 473.8 356.1 404.2

Q2 726.8 528.3 117.7 118.2 595.8 617.7 498.0 572.9

Q3 834.4 549.7 239.5 231.7 805.6 819.7 822.9 884.3

Q4 1373.0 1085.4 202.8 192.5 757.8 686.8 488.4 547.5

2008

Q1 3946.2 3835.7 234.7 221.8 1023.3 952.1 364.8 413.4

Q2 3762.9 3726.3 202.4 192.6 596.1 566.5 361.3 407.2

Q3 3077.4 2784 238.1 228.4 463.1 425.5 199.4 214.9

Q4 16824.6 16266.6 586.6 600.7 971.9 863.5 271.7 337.8

2009

Q1 1442.9 1286 143.1 167.1 867.8 950.3 168.0 225.8

Q2 806.6 764.8 95.4 100.9 1078.9 1319.4 151.6 215.6

Q3 617.7 536.8 62.1 76.7 1283.9 1553.2 145.2 192.4

Q4 245.0 184.4 141.9 163.9 3128.6 3945.1 156.7 192.2

Source: Federal Reserve Bank of New York.
44

 Box 1: Time Line of Important Events in the U.S. Repo Market

1917 Federal Reserve introduces repos; accrued interest is excluded from the 

invoice price of repo securities and repo securities are subject to automatic 

stay.

1929 Use of repos declines with the onset of the Great Depression.

1951 Congress enacts the Treasury-Federal Reserve Accord of 1951 bringing 

repos back into favor.

1982 Accrued interest is included in the invoice prices of repo securities.

1984 Congress enacts the Bankruptcy Amendments and Federal Judgeship Act of 

1984 to exempt repos on Treasury and federal agency securities, as well as 

on bank certificates of deposit and bankers’ acceptances, from the 

application of automatic stay.

2005 Congress enacts the Bankruptcy Abuse Prevention and Consumer 

Protection Act of 2005 to expand the definition of repos to include 

mortgage loans, mortgage-related securities, or interest from mortgage 

loans or mortgage securities; all mortgage-related repo securities become 

exempt from the application of automatic stay.