Working Paper: NBER ID: w15837
Authors: Viral V. Acharya; S. Viswanathan
Abstract: We build a model of the financial sector to explain why adverse asset shocks in good economic times lead to a sudden drying up of liquidity. Financial firms raise short-term debt in order to finance asset purchases. When asset fundamentals worsen, debt induces firms to risk-shift; this limits their funding liquidity and their ability to roll over debt. Firms may de-lever by selling assets to better-capitalized firms. Thus the market liquidity of assets depends on the severity of the asset shock and the system-wide distribution of leverage. This distribution of leverage is, however, itself endogenous to future prospects. In particular, short-term debt is relatively cheap to issue in good times when expectations of asset fundamentals are benign, resulting in entry to the financial sector of firms with less capital or high leverage. Due to such entry, even though the incidence of financial crises is lower in good times, their severity in terms of de-leveraging and evaporation of market liquidity can in fact be greater.
Keywords: risk-shifting; credit rationing; market liquidity; funding liquidity; fire sales; financial crises; cash-in-the-market pricing
JEL Codes: D53; G20; G30
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Adverse asset shocks (E44) | Liquidity drying up (G33) |
| High leverage (G19) | Liquidity drying up (G33) |
| Leverage structure (G32) | Severity of liquidity issues (G33) |
| Severity of asset shock (G19) | Market liquidity (G19) |
| Increased leverage during favorable conditions (G19) | Greater liquidity problems during adverse shocks (E44) |
| Leverage distribution (D39) | Expectations about future asset quality (D84) |