Outside and Inside Liquidity
The Quarterly Journal of Economics, Vol. 126, No. 1, pp. 259-321, 2011
66 Pages Posted: 22 Oct 2011 Last revised: 31 May 2012
Date Written: 2011
We propose an origination-and-contingent-distribution model of banking, in which liquidity demand by short-term investors (banks) can be met with cash reserves (inside liquidity) or sales of assets (outside liquidity) to long-term investors (hedge funds and pension funds). Outside liquidity is a more efficient source, but asymmetric information about asset quality can introduce a friction in the form of excessively early asset trading in anticipation of a liquidity shock, excessively high cash reserves, and too little origination of assets by banks. The model captures key elements of the financial crisis and yields novel policy prescriptions.
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