Institutional Liquidity Needs and the Structure of Monitored Finance

Abstract

Many financial institutions finance and monitor firms on behalf of other investors. Since monitoring gives an institution private information about its assets, the institution faces an adverse selection problem when it seeks additional funds from other investors to meet its liquidity needs; in equilibrium, some of these needs go unmet, creating liquidity costs. Liquidity costs increase with the risk of the institution's claims on the firms it monitors, so all else equal the institution can reduce its liquidity costs by holding debt rather than equity. This preference for debt should be most significant for institutions that finance firms with limited access to public markets. Among these institutions, those with less frequent or less severe liquidity needs should have a greater relative appetite for equity and for the debt of more risky borrowers. These predictions are consistent with general patterns of monitored finance and with differences across institutions.

Keywords: liquidity, financial institutions, delegated monitoring

JEL Classification: G20, G21, G22, G24, G32