Dynamic Liquidity Management with Information Asymmetry

Abstract

I provide a dynamic model of the financial intermediary’s optimal choice of cash holding and asset securitization, the two sources of liquidity to make investment. Cash holding is decided ex ante while asset securitization suffers from adverse selection problem ex post. More cash holding reduces the liquidity shortage and depresses asset securitization. The intermediary chooses the optimal cash holding, taking into account the endogenous response of asset securitization. I show that there exists a threshold such that when the minimum asset return is below the threshold, the adverse selection problem is severe, the negative effect of cash holding on asset securitization is small, and thereby the intermediaries will hold enough cash which leads asset securitization to collapse. A lower cost of holding cash encourages cash holding and makes the asset market more likely to collapse. These results hold with and without liquidity shocks, under both separating and pooling equilibrium of asset securitization, and no matter the asset minimum return is i.i.d. or decreases stochastically when credit supply increases. The paper sheds light on why banks now hold a much higher level of liquid assets and the private-label securitization market remains dead after ten years since the crisis.

Keywords: liquidity, securitization, information asymmetry, financial intermediary

JEL Classification: G01, G14, G21