Self-fulfilling liquidity dry-ups

Malherbe, F (2014) Self-fulfilling liquidity dry-ups. Journal of Finance, 69 (3). pp. 947-970. ISSN 0022-1082

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Abstract

I analyze a model in which holding cash imposes a negative externality: it worsens future adverse selection in markets for long-term assets, which impairs their role for liquidity provision. Adverse selection worsens when potential sellers of long-term assets hold more cash because then fewer sales reflect cash needs, and proportionally more sales reflect private information. Moreover, future market illiquidity makes current cash holding more appealing. This feedback effect may result in hoarding behavior and a market breakdown, which I interpret as a self-fulfilling liquidity dry-up. This mechanism suggests that imposing liquidity requirements on financial institutions may backfire.

Item Type: Article
Additional Information: © 2014 the American Finance Association
Subject Areas: Economics
DOI: 10.1111/jofi.12063
Date Deposited: 02 Mar 2016 18:51
Last Modified: 03 Nov 2016 14:26
URI: http://lbsresearch.london.edu/id/eprint/94

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