The recent debt crisis on Wall Street illustrates an intertwined relationship between market liquidity and financial firmsocredit risk. On one hand, as financial firmsocredit risk worsens, they are reluctant/unable to provide market liquidity; on the other, as market liquidity deteriorates, financial firmsodebt crisis also intensifies.1 Understanding this intertwined relationship is probably one of the most important research topics confronting the finance literature. This paper aims to analyze the second part of this relationships how does deteriorating market liquidity intensify a debt crisis?
The extant literature has proposed several mechanisms to this question. Marketilliquidity, together with the diffi culty of creditors in coordinating their rollover decisions of a firmos short'term debt, could lead to runs on financial firms, e.g., He and Xiong (2009) and Morris and Shin (2009). Deteriorating liquidity and rising volatility also motivate creditors to increase the required margins on their collateralized loans to the firms, which in turn could force the firms to liquidate their positions in illiquid markets, e.g., Brunnermeier and Pedersen (2009), Acharya, Gale, and Yorulmzer (2009), and Shleifer and Vishny (2009). These mechanisms all rely on an implicit assumption that firms are constrained from raising more equity during financial distresses. However, this assumption seems at odds with the observation that in the current crisis many financial firms paid a substantial amount of dividends despite their financial distresses and the angry creditors.2 This indicates an intricate interaction between debt and equity holders, which is missing from the aforementioned theories.
We provide a theoretical model to explicitly analyze the conflict of interest between debt and equity holders in debt crises. We show that even in the absence of any constraint on raising more equity, deteriorating market liquidity could exacerbate the conflict and lead equity holders to choose default at a higher fundamental threshold.
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Liquidity and Short'term Debt Crises
