Highlights :

• We study the liquidity channel of the European financial crisis through the market of repurchase agreements (repos), where peripheral government bonds experienced a sharp increase in haircuts.
• This liquidity shock leads to a drop in economic activity and inflation, and a "flight-to-liquidity" towards the government bonds with lower haircuts amplifying the raise in peripheral bonds yields.
• An unconventional policy which consists of purchasing illiquid bonds, similar to the expanded asset purchase program implemented by the ECB, is successful in alleviating the contractionary effect of the liquidity shock.

 Abstract :
This paper analyses the European financial crisis through the lens of sovereign bond liquidity. Using novel data we show that government securities are the prime collateral in the European repo market, which is becoming an essential source of funding for the banking system in the Euro area. We document that repo haircuts on peripheral government bonds sharply increased during the crisis, reducing their liquidity and amplifying the raise in the yields of these securities. We study the systemic impact of a liquidity shock on the business cycle and asset prices through a dynamic stochastic general equilibrium model with liquidity frictions. The model predicts a drop in economic activity, inflation and value of illiquid government bonds. We show that an unconventional policy which consists of purchasing illiquid bonds by issuing liquid bonds can alleviate the contractionary effect of liquidity shock. A Bayesian structural vector autoregressive model for the Irish economy confirms empirically the negative impact of a rise in haircuts on the value of government bonds.

 Keywords : repo | haircuts | government bonds | liquidity shock | quantitative easing

 JEL : E44, E58, G12