“Where did all the liquidity go? Six months ago, everybody was talking about boundless global liquidity supporting risky assets, driving risk premiums to virtually nothing, and now everybody is talking about a global liquidity crunch, driving risk premiums half the distance to the moon. Tell me, Mac, where did all the liquidity go?” - Paul McCulley, PIMCO Investment Outlook, Summer 2007.
Since the seminal contribution of Amihud and Mendelson (1986), the literature on asset pricing with trading frictions has burgeoned. Indeed, many would regard asset pricing with frictions as a new branch of financial economics. The general approach to research in this area is to posit or model the trading friction and analyze its impact on asset prices. On the one hand, the literature on market microstructure, starting with Glosten and Milgrom (1985) and Kyle (1985), has provided a foundation for trading frictions such as bid-ask spread and price impact by appealing to information asymmetry problem between traders and specialists or market-makers. On the other hand, a recent strand of literature (Gromb and Vayanos, 2002 and Brunnermeier and Pedersen, 2005) has recognized that the balance-sheet liquidity of traders is limited due to constraints such as collateral and margin requirements imposed by counterparties and financiers. This limited funding liquidity affects and is affected by the trading liquidity in markets.
While this latter strand of literature has taken an important stride forward in linking the corporate-finance idea of funding liquidity and the asset pricing idea of market liquidity, it has not yet modeled explicitly the micro foundations underpinning funding liquidity. We fill this important gap in the literature. We recognize that constraints such as collateral and margin requirements are themselves an endogenous response to mitigate underlying agency problems between those who provide finance and those who receive finance, or more generally, between any two parties engaging in trade. We show that collateral constraints and market illiquidity are both manifestations of underlying agency problems in our model, and market liquidity would be in fact far worse if collateral was not in in place to ameliorate agency problems. In the same vein, our model also provides an agency-theoretic explanation for some features of financial crises such as the linkage between market and funding liquidity and deep discounts observed in prices during crises that follow good times.
Since the backdrop we have in mind is one of trading-based financial institutions which are typically highly levered, we focus on the agency problem of asset substitution or risk-shifting by borrowers (Jensen and Meckling, 1976). Related to the work of Stiglitz and Weiss (1981) and Diamond (1989), this risk-shifting problem rations potential borrowers, that is, limits the maximum amount of financing they can raise from lenders. In this setting, we show that a collateral requirement – the pledging of cash that can be seized by financiers in case of borrower default – relaxes the extent of rationing. This simple agency-theoretic set-up forms the building block of our benchmark model.
To analyze asset-pricing implications, we cast this building block in a general equilibrium. Specifically, there is a continuum of firms which have undertaken some ex-ante financing (ex-ogenous initially in the paper, endogenized later in the paper). The need to repay this ex-ante financing gives rise to liquidity shocks faced by firms in that asset liquidations may not be feasible on demand to meet these shocks. Thus, firms attempt to meet liquidity shocks by raising external financing, but its extent is limited due to the risk-shifting problem. Firms which are rationed by this agency problem attempt to relax the problem by pledging cash as collateral, which requires them to liquidate some or all of their assets. These liquidated assets are acquired by the set of remaining firms in the economy (as in the industry equilibrium approach of Shleifer and Vishny, 1992). Though these remaining firms are able to meet their own liquidity shocks, they also potentially face the moral hazard problem, which limits their financing for asset purchase. Thus, the liquidation price, determined by the market-clearing condition, reflects the so-called “cash-in-the-market” pricing (a term introduced by Allen and Gale, 1994): When a large number of firms are liquidating assets, market price is below the expected discounted cash flow and is affected by the distribution of liquidity in the economy.
