Self-Fulfilling Liquidity Dry-Ups

Abstract

This paper presents a model in which cash holding imposes a negative externality because it worsens future adverse selection in markets for long-term assets, which impairs their role for liquidity provision. Adverse selection worsens when potential sellers of long-term assets hold more cash because then fewer sales reflect cash needs, and proportionally more sales reflect private information. Moreover, future market illiquidity makes current cash holding more appealing. This feedback effect may result in hoarding behavior and a market breakdown, which I interpret as a self-fulfilling liquidity dry-up. This mechanism suggests that imposing liquidity requirements on financial institutions may backfire.

Keywords: Hoarding, Cash holding, Adverse selection, Externality, Liquididy requirements, Toxic assets

JEL Classification: D62, D82, E58, G01, G21, G28