Liquidity Freezes Under Adverse Selection

Abstract

This paper analyses how adverse selection prevents liquidity from flowing from liquid to illiquid firms, thus impairing the transmission mechanism of policy. Contrary to the results in the literature, simply increasing the availability of liquidity does not solve the adverse selection problem. When there are aggregate shocks, authorities face a policy dilemma if their single policy tool is to manipulate the price of liquidity. We consider alternative policies which address the problem in a time-consistent fashion.

Keywords: liquidity; adverse selection; funding liquidity risk; financial market freezes

JEL Classification: E44, E52, G28