The Illiquidity Fog

Abstract

This paper develops a theory of how heterogeneity in bank capital choices due to differences in beliefs about the likelihood of a future crisis state leads to partially frozen credit markets in a crisis — some banks have continued access to funding liquidity but others do not, creating an “illiquidity fog”. Interbank trading in legacy assets allows some frozen banks to sell assets to obtain funding. Consequently, there is a reallocation of access to market funding from low-capital banks to high-capital banks. There are strategic complementarities in the capital choices of high-capital and low-capital banks, leading to a “capital structure contagion”.