Market Illiquidity, Credit Freezes and Endogenous Funding Constraints

Manuel Bachmann

Publication: Working/Discussion PaperWU Working Paper

Abstract

In this paper I propose a two-step theoretical extension of the baseline model by Diamond and Rajan (2011) and examine the amplification mechanisms when collateralized funding shocks are endogenously affected by liquidity shocks. Based on high returns on illiquid assets that are potentially available conditional on future fire sales, liquid banks increase their cash holdings by limiting term lending - a speculative motive of liquidity hoarding directly aggravated by a cash reduction due to increased haircuts
on collateralized borrowing. As a result, funding liquidity shrinks steadily and credit freezes are more likely. On the other hand, illiquid banks refuse to sell more illiquid
assets than necessary to meet depositors' claims - a speculative motive of illiquidity seeking indirectly amplified as fire sale prices are endogenously depressed via increased collateral requirements. Illiquid banks are forced to sell more assets, the problem of insolvency becomes more severe and market freezes are thus even more likely.
Original languageEnglish
Publication statusPublished - 2018

Publication series

NameDepartment of Economics Working Paper Series
No.255

WU Working Paper Series

  • Department of Economics Working Paper Series

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