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Market Illiquidity, Credit Freezes and Endogenous Funding Constraints

Manuel Bachmann ()
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Manuel Bachmann: Department of Economics, Vienna University of Economics and Business

Department of Economics Working Papers from Vienna University of Economics and Business, Department of Economics

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.

Keywords: Fire Sales; Insolvency; Market & Credit Freezes; Collateralized Borrowing (search for similar items in EconPapers)
JEL-codes: G01 G12 G21 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ban and nep-dge
Date: 2018-01
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