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This paper presents a model of repo rehypothecation in which dealers intermediate funds and collateral between cash lenders (e.g., money market funds) and prime brokerage clients (e.g., hedge funds). Dealers take advantage of their position as intermediaries, setting different repo terms with each counterparty. In particular, the difference in haircuts represents a positive cash balance for the dealer that can be an important source of liquidity. The model shows that dealers with higher default risk are more exposed to runs by collateral providers than to runs by cash lenders, who are completely insulated from a dealer’s default. In addition, collateral providers’ repo terms are sensitive to changes in a dealer’s de- fault probability and its correlation with the collateral’s outcome, whereas cash lenders’ repo terms are unaffected by these changes. This paper rationalizes the difference in haircuts observed in bilateral and tri-party repo markets, reconciles the partial evidence of the run on repo during the recent financial crisis, and presents new empirical evidence to support the model’s main prediction on haircut sensitivities.

This study seeks to understand the interplay between banks, bank regulation, sovereign default risk and central bank guarantees in a monetary union. I assume that banks can use sovereign bonds for repurchase agreements with a common central bank, and that their sovereign partially backs up any losses should the banks not be able to repurchase the bonds. I argue that regulators in risky countries have an incentive to allow their banks to hold home risky bonds and risk defaults, whereas regulators in other ‘safe’ countries will impose tighter regulation. As a result, governments in risky countries get to borrow more cheaply, effectively shifting the risk of some of the potential sovereign default losses on the common central bank.