LEVERAGE, MORAL HAZARD AND LIQUIDITY

We build a model of the financial sector to explain why adverse asset shocks in good economic timeslead to a sudden drying up of liquidity. Financial firms raise short-term debt in order to finance assetpurchases. When asset fundamentals worsen, debt induces firms to risk-shift; this limits their fundingliquidity and their ability to roll over debt. Firms may de-lever by selling assets to better-capitalizedfirms. Thus the market liquidity of assets depends on the severity of the asset shock and the system-widedistribution of leverage. This distribution of leverage is, however, itself endogenous to future prospects.particular, short-term debt is relatively cheap to issue in good times when expectations of asset fundamentalsare benign, resulting in entry to the financial sector of firms with less capital or high leverage. Dueto such entry, even though the incidence of financial crises is lower in good times, their severity interms of de-leveraging and evaporation of market liquidity can in fact be greater....