Abstract
This paper presents a dynamic asset pricing model of Treasury bonds with banks subject to both capital and liquidity requirements. Capital requirements and households’ preference for money-like assets push non-banks to be the primary holders of Treasuries, thereby exposing Treasury yields to funding shocks originating in repo markets. When holding sufficient reserves, banks mitigate those shocks by lending in repo when the funding supply tightens. When reserves are scarce, banks stop lending. Repo rates and Treasury yields spike up to reflect those funding imbalances. Our model highlights the key role of both sides of the central bank's balance sheet as well as agents' anticipation about the duration of shocks and policy intervention in explaining observed Treasury market disruptions.