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Self‐Fulfilling Liquidity Dry‐Ups
Author(s) -
MALHERBE FREDERIC
Publication year - 2014
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/jofi.12063
Subject(s) - market liquidity , adverse selection , hoarding (animal behavior) , cash , monetary economics , externality , business , liquidity crisis , liquidity risk , economics , finance , microeconomics , ecology , foraging , biology
I analyze a model in which holding cash imposes a negative externality: it worsens future adverse selection in markets for long‐term assets, which impairs their role for liquidity provision. Adverse selection worsens when potential sellers of long‐term assets hold more cash because then fewer sales reflect cash needs, and proportionally more sales reflect private information. Moreover, future market illiquidity makes current cash holding more appealing. This feedback effect may result in hoarding behavior and a market breakdown, which I interpret as a self‐fulfilling liquidity dry‐up. This mechanism suggests that imposing liquidity requirements on financial institutions may backfire.