Leverage, Moral Hazard and Liquidity

46 Pages Posted: 29 Mar 2010 Last revised: 10 Apr 2023

See all articles by Viral V. Acharya

Viral V. Acharya

New York University (NYU) - Leonard N. Stern School of Business; New York University (NYU) - Department of Finance; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI); National Bureau of Economic Research (NBER)

S. Viswanathan

Duke University - Fuqua School of Business; Duke University - Department of Economics

Multiple version iconThere are 3 versions of this paper

Date Written: March 2010

Abstract

We build a model of the financial sector to explain why adverse asset shocks in good economic times lead to a sudden drying up of liquidity. Financial firms raise short-term debt in order to finance asset purchases. When asset fundamentals worsen, debt induces firms to risk-shift; this limits their funding liquidity and their ability to roll over debt. Firms may de-lever by selling assets to better-capitalized firms. Thus the market liquidity of assets depends on the severity of the asset shock and the system-wide distribution of leverage. This distribution of leverage is, however, itself endogenous to future prospects. In particular, short-term debt is relatively cheap to issue in good times when expectations of asset fundamentals are benign, resulting in entry to the financial sector of firms with less capital or high leverage. Due to such entry, even though the incidence of financial crises is lower in good times, their severity in terms of de-leveraging and evaporation of market liquidity can in fact be greater.

Suggested Citation

Acharya, Viral V. and Acharya, Viral V. and Viswanathan, S., Leverage, Moral Hazard and Liquidity (March 2010). NBER Working Paper No. w15837, Available at SSRN: https://ssrn.com/abstract=1578675

Viral V. Acharya (Contact Author)

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New York University (NYU) - Department of Finance ( email )

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S. Viswanathan

Duke University - Fuqua School of Business ( email )

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Duke University - Department of Economics

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