Leverage, Moral Hazard, and Liquidity

In the paper, Leverage, Moral Hazard, and Liquidity, forthcoming in the Journal of Finance (February 2011), the authors argue that the buildup of leverage in the financial sector in good economic times helps explain why adverse asset shocks in such times are associated with a severe drying-up of liquidity and deep discounts in asset prices. We illustrate that while the incidence of financial crises is lower when expectations of fundamentals are good, their severity can in fact be greater in such times due to greater system-wide leverage.

The core foundation of their theoretical model lies in the idea that when adverse asset shocks wipe out capital base of financial intermediaries, their short-term debt cannot be rolled over due to attendant agency problems, in particular, due to the problem that intermediaries may gamble excessively if leverage is not reduced. They tie this problem of rollover risk with the following facts: (i) the prominence of short-term rollover debt in the capital structure of financial firms, and (ii) the low cost of rollover debt in good economic times, which leads to the entry of highly leveraged firms in the financial sector. All of these factors played an important role in the financial crisis of 2007 to 2009 and the period preceding it.

In somewhat greater detail, their explanation for sudden liquidity crises is as follows. Short-term rollover debt implies that when adverse asset shocks materialize, most leveraged firms must de-lever and sell assets to less leveraged firms, potentially at fire-sale prices and with losses to their creditors. However, in good economic times, such adverse asset shocks are not too likely. Further, creditors ignore any externalities related to asset fire sales. Hence, short-term debt is relatively cheap in good economic times. This implies in turn that on the margin, even poorly capitalized – or highly leveraged – financial firms and their bets can be financed in good times. This entry of highly leveraged firms then guarantees that if adverse asset shocks do materialize, then there is substantial de-leveraging and fire sale of assets, with coincident drops in market and funding liquidity, all symptoms of financial crises. To summarize, abundant liquidity evaporates as financial intermediaries become short on capital. Indeed, crises arising from good times when macroeconomic expectations are benign can thus be far more severe than crises arising from times with less benign expectations.

The full paper is available for download here.