Who Will Guard the Guards? (Quis Custodiet Ipsos Custodes?)

Abstract:     
Trading firms, whom we entrust the job of providing liquidity, may exacerbate liquidity shocks to the economy and furthermore, reduce efficacy of liquidity injections by the state. Unlike traditional banks, trading firms observe their losses privately and have incentives to avoid revealing losses due to the fear of a bank run by investors and counter-parties. Hence, even if central banks stand ready to guarantee liquidity, due to the pooling behavior of trading firms, liquidity allocation will be inefficient. This prolongs the liquidity crisis, as firms in red use injected liquidity to stave off bank runs, while other firms may use new liquidity to take predatory positions. The moral hazard problem is also exacerbated as firms taking excessive risk are provided cheap money. Hence, we suggest a different approach in this paper: to avoid the pooling equilibrium between firms in black and in red, a separating equilibrium is encouraged where all the liquidity is provided to firms with stronger balance sheets, allowing them to absorb the assets of the firms facing losses. As the firms with better books compete against each other with new found liquidity, and the firms in red exit, the liquidity in capital markets also improves quickly.

Keywords: Liquidity, Systemic Risk, Leverage, Margins, Haircuts, Value-at-Risk, Credit Crunch, Counterparty Credit Risk, Financial crises, Incomplete markets, Insurance

JEL Classifications: E32, E44, G13, G21

Working Paper Series