The Economic Consequences of 'Market-Based' Lending

The growth of “market-based” lending is closely related to the growth of repurchase agreements and similar contracts that grant the lender the right to sell collateral on the market if a threshold level of over-collateralization is not maintained. This paper argues that this contractual structure relies so heavily on market liquidity that its ubiquitous use has the paradoxical effect of disrupting market liquidity itself. The paper takes a Keynesian view of market liquidity as prone to crises of confidence and thus fundamentally unstable. It develops an analytic framework that explains how the economic function of the traditional banking system is to act as a shock absorber for the liquidity crises that are inherent to markets. The growth of “market-based” lending and in particular its culmination in the development of a money market that is dominated by repurchase agreements and other collateralized instruments is analyzed using this framework.This paper argues that the growth of repurchase and margin contracts has created an environment where liquidity crises are endemic. In this environment even in normal times market participants seek to self-insure by holding “safe haven” assets that are unlikely to fall in value in a liquidity crisis. Thus, this structural shift in the financial system explains (i) the decline in real interest rates that started in the late 1990s, (ii) the increase in the spreads between “safe” and riskier assets, and (iii) the lackluster economic performance that has led to concerns about secular stagnation.