Working Paper: NBER ID: w12887
Authors: Nicolae B. Garleanu; Lasse H. Pedersen
Abstract: This paper provides a model of the interaction between risk-management practices and market liquidity. On one hand, tighter risk management reduces the maximum position an institution can take, thus the amount of liquidity it can offer to the market. On the other hand, risk managers can take into account that lower liquidity amplifies the effective risk of a position by lengthening the time it takes to sell it. The main result of the paper is that a feedback effect can arise: tighter risk management reduces liquidity, which in turn leads to tighter risk management, etc. This can help explain sudden drops in liquidity and, since liquidity is priced, in prices in connection with increased volatility or decreased risk-bearing capacity.
Keywords: No keywords provided
JEL Codes: G10
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Tighter risk management (H12) | Reduced market liquidity (G19) |
| Reduced market liquidity (G19) | Tighter risk management (H12) |
| Tighter risk management (H12) | Tighter risk management (H12) |
| Reduced market liquidity (G19) | Increased volatility (E32) |
| Tighter risk management (H12) | Reduced risk-bearing capacities (G32) |