Self‐Fulfilling Liquidity Dry‐Ups

  • Author(s): FREDERIC MALHERBE
  • Published: Mar 17, 2014
  • Pages: 947-970
  • DOI: 10.1111/jofi.12063

ABSTRACT

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.

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