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Illiquidity and all its Friends

  • Jean Tirole

    (Toulouse School of Economics)

The recent crisis was characterized by massive illiquidity. This paper reviews what we know and don't know about illiquidity and all its friends: market freezes, fire sales, contagion, and ultimately insolvencies and bailouts. It first explains why liquidity cannot easily be apprehended through a single statistics, and asks whether liquidity should be regulated given that a capital adequacy requirement is already in place. The paper then analyzes market breakdowns due to either adverse selection or shortages of financial muscle, and explains why such breakdowns are endogenous to balance sheet choices and to information acquisition. It then looks at what economics can contribute to the debate on systemic risk and its containment. Finally, the paper takes a macroeconomic perspective, discusses shortages of aggregate liquidity and analyses how market value accounting and capital adequacy should react to asset prices. It concludes with a topical form of liquidity provision, monetary bailouts and recapitalizations, and analyses optimal combinations thereof; it stresses the need for macro-prudential policies.

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Paper provided by Fondazione Eni Enrico Mattei in its series Working Papers with number 2010.78.

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Date of creation: Jun 2010
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Handle: RePEc:fem:femwpa:2010.78
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  1. Bengt Holmstrom & Jean Tirole, 1998. "Private and Public Supply of Liquidity," Journal of Political Economy, University of Chicago Press, vol. 106(1), pages 1-40, February.
  2. Woodford, Michael, 1990. "Public Debt as Private Liquidity," American Economic Review, American Economic Association, vol. 80(2), pages 382-88, May.
  3. Heider, F. & Hoerova, M. & Holthausen, C., 2009. "Liquidity Hoarding and Interbank Market Spreads : The Role of Counterparty Risk," Discussion Paper 2009-40 S, Tilburg University, Center for Economic Research.
  4. Gary Gorton & George Pennacchi, 1991. "Security Baskets and Index-Linked Securities," NBER Working Papers 3711, National Bureau of Economic Research, Inc.
  5. Ben S. Bernanke & Mark Gertler, 2001. "Should Central Banks Respond to Movements in Asset Prices?," American Economic Review, American Economic Association, vol. 91(2), pages 253-257, May.
  6. Guillaume Plantin & Haresh Sapra & Hyun Shin, . "Marking to Market: Panacea or Pandora’s Box ?," GSIA Working Papers 2005-E4, Carnegie Mellon University, Tepper School of Business.
  7. Kenneth A. Froot & David S. Scharfstein & Jeremy C. Stein, 1992. "Risk Management: Coordinating Corporate Investment and Financing Policies," NBER Working Papers 4084, National Bureau of Economic Research, Inc.
  8. Aghion, Philippe & Bolton, P. & Tirole, J., 2004. "Exit Options in Corporate Finance: Liquidity versus Incentives," Scholarly Articles 12500289, Harvard University Department of Economics.
  9. Subrahmanyam, Avanidhar, 1991. "A Theory of Trading in Stock Index Futures," Review of Financial Studies, Society for Financial Studies, vol. 4(1), pages 17-51.
  10. Jean-Charles Rochet & Jean Tirole, 1996. "Interbank lending and systemic risk," Proceedings, Board of Governors of the Federal Reserve System (U.S.), pages 733-765.
  11. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
  12. Benjamin J. Keys & Tanmoy Mukherjee & Amit Seru & Vikrant Vig, 2010. "Did Securitization Lead to Lax Screening? Evidence from Subprime Loans," The Quarterly Journal of Economics, MIT Press, vol. 125(1), pages 307-362, February.
  13. Goodhart, C., 2008. "Liquidity risk management," Financial Stability Review, Banque de France, issue 11, pages 39-44, February.
  14. Harald Uhlig, 2009. "A Model of a Systemic Bank Run," NBER Working Papers 15072, National Bureau of Economic Research, Inc.
  15. Akerlof, George A, 1970. "The Market for 'Lemons': Quality Uncertainty and the Market Mechanism," The Quarterly Journal of Economics, MIT Press, vol. 84(3), pages 488-500, August.
  16. Hirshleifer, Jack, 1971. "The Private and Social Value of Information and the Reward to Inventive Activity," American Economic Review, American Economic Association, vol. 61(4), pages 561-74, September.
  17. Ricardo J. Caballero & Arvind Krishnamurthy, 2003. "Excessive Dollar Debt: Financial Development and Underinsurance," Journal of Finance, American Finance Association, vol. 58(2), pages 867-894, 04.
  18. Myers, Stewart C. & Majluf, Nicolás S., 1945-, 1984. "Corporate financing and investment decisions when firms have information that investors do not have," Working papers 1523-84., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  19. Bruno Biais & Thomas Mariotti & Jean-Charles Rochet & Stéphane Villeneuve, 2010. "Large risks, limited liability, and dynamic moral hazard," Working Papers 245707, Institut National de la Recherche Agronomique, France.
  20. Bengt Holmstrom & Jean Tirole, 1994. "Financial Intermediation, Loanable Funds and the Real Sector," Working papers 95-1, Massachusetts Institute of Technology (MIT), Department of Economics.
  21. Biais, Bruno & Mariotti, Thomas & Plantin, Guillaume & Rochet, Jean-Charles, 2004. "Dynamic Security Design: Convergence to Continuous Time and Asset Pricing Implications," IDEI Working Papers 312, Institut d'Économie Industrielle (IDEI), Toulouse, revised Sep 2006.
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