Moral Hazard, Collateral and Liquidity

Acharya, V V and Viswanathan, S (2007) Moral Hazard, Collateral and Liquidity. Working Paper. London Business School IFA Working Paper.

Abstract

We consider a moral hazard setup wherein leveraged firms have incentives to take on excessive risks and are thus rationed when they attempt to roll over debt. Firms can optimally pledge cash as collateral to reduce rationing, but in the process must liquidate some of their assets. Liquidated assets are purchased by nonrationed firms but their borrowing capacity is also limited by the risktaking moral hazard. The marketclearing price exhibits cashinthemarket pricing and depends on the entire distribution of leverage (debt to be rolled over) in the economy. This distribution of leverage, and indeed its very form as rollover debt, are derived as endogenous outcomes with each firm’s choice of leverage anticipating the difficulty for all firms in rolling over debt in future. The model provides a natural linkage between market liquidity and funding liquidity, shows that optimally designed collateral requirements have a stabilizing effect on prices, and illustrates the possible role of leverage in generating deep discounts in prices when adverse assetquality shocks materialize in good times.