Researchers from Duke University and Fuqua School of Business examine the desirability of granting “safe harbor” provisions to creditors of financial intermediaries in sale-and-repurchase (repo) contracts. Exemption from an automatic stay in bankruptcy enables financial intermediaries to raise greater liquidity and induces entry of intermediaries with higher leverage during normal times.
This liquidity creation occurs, however, at the cost of ex-post inefficiency when there are adverse aggregate shocks to the fundamental quality of collateral underlying the contracts. When exempt from bankruptcy, creditors of highly leveraged financial intermediaries respond to such shocks by engaging in collateral liquidations. Financial arbitrage by less leveraged financial intermediaries equilibrates returns from acquiring collateral at fire-sale prices and returns from real-sector lending, inducing higher lending rates, a deterioration in endogenous asset quality, and in the extremis, a credit crunch for the real sector.
Given this distributive externality, taming the leverage cycle by not granting safe harbors, i.e., requiring an automatic stay on repo contracts in bankruptcy, can be not only ex-post optimal, but also ex-ante optimal, especially for illiquid collateral with high exposure to aggregate risk.