Idiosyncratic Liquidity Shocks Research Articles

Once Burned, Twice Shy: Money Market Fund Responses to a Systemic Liquidity Shock

In the immediate aftermath of the Lehman collapse, investors ran from risky money market funds. In 27 of them, outflows were large enough to overwhelm cash inflows from maturing assets, thus forcing asset sales. We find that these money funds responded by selling their safest and most liquid holdings. As a result, funds were left holding higher risk and longer maturity assets than desired. Over the subsequent quarter, however, the hard-hit funds reduced risk more than other funds, relative to their initial holdings before the crisis. In contrast, money funds hit by idiosyncratic liquidity shocks before the Lehman crisis did not alter portfolio risk. The result suggests that moral hazard concerns associated with the Treasury Guarantee of money market investor claims did not lead to increased risk taking. Rather than increase risk, funds that benefitted most from the government bailout reduced risk.

Money, Financial Stability and Efficiency

Most analyses of banking crises assume that banks use real contracts. However, in practice, contracts are nominal and this is what is assumed here. We consider a standard banking model with aggregate return risk, aggregate liquidity risk and idiosyncratic liquidity shocks. We show that, with non-contingent nominal deposit contracts, the first-best efficient allocation can be achieved in a decentralized banking system. What is required is that the central bank accommodates the demands of the private sector for fiat money. Variations in the price level allow full sharing of aggregate risks. An interbank market allows the sharing of idiosyncratic liquidity risk. In contrast, idiosyncratic (bank-specific) return risks cannot be shared using monetary policy alone; real transfers are needed.

Public Debt under Limited Private Credit

There is a conventional wisdom in economics that public debt can serve as a substitute for private credit if private borrowing is limited. The purpose of this paper is to show that, while a government could in principle use such a policy to fully relax borrowing limits, this is not generally optimal. In our economy, agents invest in a short term asset, a long term asset, and government bonds. Agents are subject to idiosyncratic liquidity shocks prior to the maturity of the long term asset. We show that a high public debt policy fully relaxes private borrowing limits and is suboptimal. This is because agents expecting such a policy respond by investing less than is socially optimal in the short asset which can protect them in the event of a liquidity shock. The optimal policy is more constrained and it induces a wedge between the technological rate of return on the long asset and the rate of return on bonds. In such a regime, agents subject to liquidity shocks are also borrowing constrained, and this expectation of being borrowing constrained induces them to invest the optimal level in the short asset.

Bank Competition and Economic Stability: The Role of Monetary Policy

This paper analyzes the dual role of monetary policy for economic efficiency and stability in a model of endogenous bank competition. Multiple equilibria emerge from the complementarity between bank and non-financial firm decisions. Adverse aggregate or idiosyncratic liquidity shocks may cause a breakdown in which the economy collapses into a no-production equilibrium. Less bank competition improves the profitability of banks and makes the economy less vulnerable to adverse shocks but it also distorts the efficient allocation of capital. This stability/efficiency tradeoff creates a motive for monetary policy to be tight when liquidity is abundant to spur bank competition and to be loose in bad times to restore the profitability of banks and decrease the likelihood of economic and financial crashes.

Financial Integration, Liquidity and the Depth of Systemic Crises

This paper investigates how …nancial integration aects banks'liquidity holding and the depth of systemic crises. We model a two-region economy, where each region is charac- terized by idiosyncratic liquidity shocks that cannot be insured in autarky. Financial inte- gration allows banks in dierent regions to coinsure through an interbank deposit market, however integration can leave some residual aggregate uncertainty and liquidity coinsurance is not always possible. Nevertheless, …nancial integration reduces the liquidity uncertainty and increases welfare. Under plausible conditions, …nancial integration induces banks to reduce their liquidity holdings to take advantage of illiquid long term investments with higher returns. In this way, integration opens up the opportunity for the occurrence of extreme events: If both regions have high liquidity needs the interbank market freezes and the cost of liquidity can become unusually high. Furthermore, with respect to autarky, the distribution of consumption can display both higher volatility and negative skewness. The model is consistent with recent trends in banks external positions and liquidity holdings in both the US and the Euro Area, and it sheds some light on the determinants of the extreme events occurred during the recent …nancial crisis.

Banks, markets, and efficiency

A competitive financial system can help reduce banks’ monopoly power and the associated inefficiencies. However, according to Diamond (J Polit Econ 105: 928–956, 1997) and Fecht (J Eur Econ Assoc 6(2), 2004) competition with the financial sector may also constrain the amount of liquidity insurance that banks can provide to households affected by unobservable idiosyncratic liquidity shocks. To study this trade-off, we model competition between banks and between banks and financial markets. Our analysis shows that competition between banks and financial markets can constrain the risk-sharing offered by deposit contracts. This effect is the same if competition between banks mainly affects the reallocation of deposits. However, if banking competition primarily affects new deposits, then such competition only limits inefficient monopoly rents without restraining risk-sharing.

Banking, Markets, and Efficiency

Following Diamond (1997) we use a model in which financial market access of households restrains the efficiency of the liquidity insurance that banks' deposit contracts provide to households that are subject to idiosyncratic liquidity shocks. But in contrast to these approaches we assume spatial monopolistic competition among banks. Since monopoly rents are assumed to bring about inefficiencies, improved financial market access that limits monopoly rents also entails a positive effect. But this beneficial effect is only relevant if competition among banks does not sufficiently restrain monopoly rents already. Thus, our results suggest that in the bank-dominated financial system of Germany, in which banks intensely compete for households' deposits, improved financial market access might reduce welfare because it only reduces risk sharing. In contrast, in the banking system of the U.S., with less competition for households' deposits, a high level of households' financial market participation might be beneficial.

Financial Intermediaries, Markets, and Growth

We build a model in which financial intermediaries provide insurance to households against idiosyncratic liquidity shocks. Households can invest in financial markets directly if they pay a cost. In equilibrium, the ability of intermediaries to share risk is constrained by the market. From a growth perspective, this can be beneficial because intermediaries invest less in the productive technology when they provide more risk‐sharing. Our model predicts that bank‐oriented economies can grow more slowly than more market‐oriented economies, which is consistent with some recent empirical evidence.

Systemic Liquidity and the Composition of Foreign Investment: Theory and Empirical Evidence

Foreign direct investors are more informed than foreign portfolio investors regarding changes in the prospects of their projects. This inside information, acquired through rigorous monitoring of management, enables foreign direct investors to manage their firms more efficiently. Having better information, however, comes at a cost. If projects can be liquidated prematurely because of liquidity shocks, the price foreign direct investors get is lower than the price foreign portfolio investors could obtain. This is due to the asymmetry of information between buyers and sellers in the capital market. We develop a theory of the effect of aggregate, and idiosyncratic liquidity shocks on the composition of foreign investment. We also demonstrate how capital market transparency affects the composition of foreign investment. A key prediction of the theory is that source countries with higher probability of aggregate liquidity crises will export relatively more FPI and less FDI. To test this hypothesis, we apply a dynamic panel model to examine the variation of FPI relative to FDI for 140 source countries from 1990 to 2004. Our key variable is the probability, estimated from a Probit model, of liquidity shocks, as proxied by episodes of economy wide sales of external assets. It turns out that liquidity shocks have strong effects on the composition of foreign investment, as predicted by our model. Moreover, higher opacity (the inverse of transparency) in the source country accelerates the effect of the probability of liquidity shock on FPI/FDI. We repeat this analysis using real interest rate hikes, or big real exchange rate depreciation, as an alternative indicator of a liquidity crisis, and get similar results.

Banks, Markets, and Efficiency

Following Diamond (1997) and Fecht (2004) we use a model in which financial market access of households restrains the efficiency of the liquidity insurance that banks' deposit contracts provide to households that are subject to idiosyncratic liquidity shocks. But in contrast to these approaches we assume spacial monopolistic competition among banks. Since monopoly rents are assumed to bring about inefficiencies, improved financial market access that limits monopoly rents also entails a positive effect. But this beneficial effect is only relevant if competition among banks does not sufficiently restrain monopoly rents already. Thus our results suggest that in the bank-dominated financial system of Germany, in which banks intensely compete for households' deposits, improved financial market access might reduce welfare because it only reduces risk sharing. In contrast, in the banking system of the U.S., with less competition for households' deposits, a high level of households' financial market participation might be beneficial.

Commonality in liquidity: transmission of liquidity shocks across investors and securities

What are the causes and consequences of commonality in liquidity? We examine this issue using a model of liquidity trading in which liquidity shocks are decomposed into common (systematic) and idiosyncratic components. We show that common liquidity shocks do not give rise to commonality in trading volume. Indeed, trading volume is independent of systematic liquidity risk, and this risk is always priced irrespective of market liquidity. In contrast, idiosyncratic liquidity shocks create liquidity demand and volume, and investors can diversify their risk by trading. Hence, pricing of the risk of idiosyncratic liquidity shocks depends on market liquidity, with idiosyncratic liquidity risk being fully priced only in perfectly illiquid markets. While trading volume increases with the variance of idiosyncratic liquidity shocks, price volatility increases with the variance of both idiosyncratic and systematic liquidity shocks. Surprisingly, our results are largely independent of the number of different securities traded in the market. When asset returns are uncorrelated, there is no transmission of liquidity across assets even when investors experience common liquidity shocks, suggesting that such liquidity shocks may not be the source of commonality in liquidity across assets detected in the literature. However, under limited conditions, more liquid securities can act as substitutes for less liquid securities. Overall, our findings suggest that common factors in liquidity may be the outcome of covariation in investor heterogeneity (e.g., as measured by co-movements in the volatility of idiosyncratic liquidity shocks) rather than of common liquidity shocks. Moreover, we find that different liquidity proxies measure different things, which has implications for future empirical analysis.

Banks, Liquidity Crises and Economic Growth

How do the liquidity functions of banks affect investment and growth at different stages of economic development? How do financial fragility and the costs of banking crises evolve with the level of wealth of countries? We analyze these issues using an overlapping generations growth model where agents, who experience idiosyncratic liquidity shocks, can invest in a liquid storage technology or in a partially illiquid Cobb Douglas technology. By pooling liquidity risk, banks play a growth enhancing role in reducing inefficient liquidation of long term projects, but they may face liquidity crises associated with severe output losses. We show that middle income economies may find optimal to be exposed to liquidity crises, while poor and rich economies have more incentives to develop a fully covered banking system. Therefore, middle income economies could experience banking crises in the process of their development and, as they get richer, they eventually converge to a financially safe long run steady state. Finally, the model replicates the empirical fact of higher costs of banking crises for middle income economies