Leverage, Moral Hazard and Liquidity

Abstract

We consider a moral hazard setup wherein leveraged firms have incentives to take on excessive risks and are thus rationed when they attempt to roll over debt. Firms can sell assets to alleviate rationing. Liquidated assets are purchased by non-rationed firms but their borrowing capacity is also limited by the risk-taking moral hazard. The market-clearing price exhibits cash-in-the-market pricing and depends on the entire distribution of leverage (debt to be rolled over) in the economy. This distribution of leverage, and its form as roll-over debt, are derived as endogenous outcomes with eachfirm's choice of leverage affecting the difficulty of otherfirms in rolling over debt in future. The model provides an agency-theoretic linkage between market liquidity and funding liquidity and formalizes the de-leveraging offinancial institutions observed during crises. It also explains the role played by system-wide leverage in generating deep discounts in prices when adverse asset-quality shocks materialize in good times.