Research Digest How banks rebalance their loan portfolios in a context of sovereign debt crisis


In “The repo channel of cross-border lending in the European sovereign debt crisis”, published in the Journal of Financial Markets, ESCP Business School Professor Jaime Luque proposes a model to understand how repo markets propagate shocks that induce banks to reallocate their cross-border loan exposures by geographic region and asset type.

From a policy point of view, I argue that the 'normalization' of the sovereign crisis hit bond markets may not have only been due to the moral suasion exerted by GICIPS governments on domestic banks (...) but rather the result of the unprecedented ECB's LTRO program.

Why study this

The repo market is the main source for banks for funding their assets: by borrowing against sovereign bonds in the repo markets, banks can achieve a large long position for example on corporate loans. This liquidity stimulates economic growth through expansionary credit. But during the European sovereign debt crisis of 2010-2013, repo exchanges, such as LCH.Clearnet, raised haircuts on lower-rated sovereign bonds (they went from 0 to 45% for Irish sovereign collateral and 80% for Portugal's), eventually turning them into toxic assets. As a result, banks loaded with these countries' sovereign collateral found it difficult to obtain private repo funding.


  • When GICIPS (Greece, Italy, Cyprus, Ireland, Portugal, Spain) sovereigns become risky and lose acceptability in the repo market (i.e. the collateral risk is increased), banks engage in a flight-to-liquidity lending strategy: they rebalance their loan portfolios toward safe and liquid sovereign collateral from core European countries (e.g. German bonds).
  • This flight-to-liquidity strategy increases the spread between core and GICIPS bond yields and causes a credit squeeze in the markets of GICIPS bonds and corporate loans.
  • Worsened access to the funding market for banks in GICIPS countries induce these banks to adopt a risky-lending strategy: they rebalance their loan portfolios toward risky and illiquid sovereigns.
  • The European Central Bank's Long Term Refinancing Operations (LTRO) programme allows banks to take risky euro-denominated collateral to the ECB's long-term lending facilities at a lower repo haircut than in private repos. This effectively reduces the bond spread.
  • The potential exposure at default that the central bank may have if banks that are short in repo do not repurchase the collateral is a function of the amount of leverage that the facility permits: the risk increases with a lower repo haircut and a high level of collateral rehypothecation.

Key insight

Shocks to repo funding induce banks to reallocate credit: a higher collateral risk on lower-rated sovereigns encourages banks to fly to liquid collateral, whereas banks in the periphery sovereign crisis region with worse funding conditions rebalance their loan portfolios toward risky illiquid sovereigns.


Jaime Luque provides the first equilibrium approach to cross-border banking where repo sovereign collateral becomes “segmented”, similar to what occurred during the European sovereign debt crisis. Also a first, he examines the repo channel of central bank interventions on banks' cross-border lending strategies to reduce the spread between sovereign bonds perceived as safe and those perceived as risky.

Final takeaways

By offering a better repo haircut on illiquid GICIPS (Greece, Italy, Cyprus, Italy, Portugal, Spain) sovereigns than the market, the European Central Bank can effectively decrease the bond spread. This is consistent with the ECB and other independent studies that argue that the LTRO programme helped stabilise repo and collateral markets, and was an important tool toward normalising liquidity in collateral markets hit by the sovereign crisis.


Jaime Luque - ESCP Business School Jaime Luque Professor at ESCP Business School and Director of the the ESCP Institute of Real Estate Finance and Management