Liquidity hoarding

Abstract

Costly bankruptcy and incomplete markets cause inefficient liquidity hoarding. Banks are unable to trade contingent claims to liquidity, so they raise cash by selling illiquid assets on spot markets. Such trading increases asset-price volatility and creates the incentive to hoard liquidity. Hoarding creates a second inefficiency: the aggregate level of liquidity is inefficient too. A lender of last resort can implement the constrained-efficient allocation, but only if it intervenes so aggressively that it shuts down the private provision of liquidity altogether, becoming in effect the lender of first resort. © 2013 Douglas Gale and Tanju Yorulmazer.