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Self-fulfilling liquidity dry-ups

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  • Frédéric Malherbe

    ()
    (National Bank of Belgium, Research Department
    Université Libre de Bruxelles, ECARES)

Abstract

Secondary markets for long-term assets might be illiquid due to adverse selection. In a model in which moral hazard is confined to project initiation, I find that: (1) when agents expect a liquidity dry-up on such markets, they optimally choose to self-insure through the hoarding of non-productive but liquid assets; (2) such a response has negative externalities as it reduces ex-post market participation, which worsens adverse selection and dries up market liquidity; (3) liquidity dry-ups are Pareto inefficient equilibria; (4) the Government can rule them out. Additionally, when agents face idiosyncratic, privately known, illiquidity shocks, I show that: (5) it increases market liquidity; (6) illiquid agents are better-off when they can credibly disclose their liquidity position, but transparency has an ambiguous effect on risk-sharing possibilities.

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Bibliographic Info

Paper provided by National Bank of Belgium in its series Working Paper Research with number 185.

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Length: 44 pages
Date of creation: Mar 2010
Date of revision:
Handle: RePEc:nbb:reswpp:201003-01

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Related research

Keywords: Liquidity; Liquidity Dry-ups; Financial Crises; Hoarding; Adverse Selection; Self-insurance;

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Cited by:
  1. Bertsch, Christoph, 2013. "A detrimental feedback loop: deleveraging and adverse selection," Working Paper Series 277, Sveriges Riksbank (Central Bank of Sweden).
  2. Gale, Douglas & Yorulmazer, Tanju, 2013. "Liquidity hoarding," Theoretical Economics, Econometric Society, vol. 8(2), May.
  3. Thierfelder, Felix, 2012. "Maturity shortening and market failure," Discussion Papers 06/2012, Deutsche Bundesbank, Research Centre.
  4. Yorulmazer, Tanju, 2014. "Literature review on the stability of funding models," Economic Policy Review, Federal Reserve Bank of New York, issue Feb, pages 3-16.
  5. Vives, Xavier, 2011. "Strategic Complementarity, Fragility, and Regulation," CEPR Discussion Papers 8444, C.E.P.R. Discussion Papers.
  6. Mit, 2010. "Lemons, Market Shutdowns and Learning," 2010 Meeting Papers 1098, Society for Economic Dynamics.

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