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Self-fulfilling liquidity dry-ups

Listed author(s):
  • Frédéric Malherbe

    ()

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

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    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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    File URL: https://www.nbb.be/doc/oc/repec/reswpp/wp185en.pdf
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    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
    Handle: RePEc:nbb:reswpp:201003-01
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