Abstract
This paper builds a model to analyze how a financial institution can be trapped into a liquidity squeeze through the creditor channel. In the model, a borrower (e.g., a hedge fund) obtains funds from a wholesale large lender (e.g., a prime-broker) and small investors (e.g., client investors). When the large lender's asset market is hit by a liquidity shock, the large lender might decide to withdraw funding extended to the borrower. The potential withdrawal by the large lender causes small investors to panic, and close positions even if the large lender does not. Facing funding problems, the borrower has to cut its activities, contributing to further shocks to the supply of market liquidity. The original shock is exacerbated, which reinforces the withdrawals by the creditors. The model helps to explain that the spreading of liquidity shocks from the broker dealer sector to the hedge funds sector and the feedback caused severe illiquidity to hedge funds, which in turn contributed to the systemic crisis in 2007-2009.
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