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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.

Suggested Citation

  • Frédéric Malherbe, 2010. "Self-fulfilling liquidity dry-ups," Working Paper Research 185, National Bank of Belgium.
  • Handle: RePEc:nbb:reswpp:201003-01
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    More about this item

    Keywords

    Liquidity; Liquidity Dry-ups; Financial Crises; Hoarding; Adverse Selection; Self-insurance;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G01 - Financial Economics - - General - - - Financial Crises
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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