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Leverage, Moral Hazard, and Liquidity




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    • Viral V. Acharya is from New York University; S. Viswanathan is from Duke University. This paper was earlier circulated under the title “Moral Hazard, Collateral, and Liquidity.” The authors are grateful to Bruno Biais, Patrick Bolton, Peter DeMarzo, Doug Diamond (acting editor), Darrell Duffie, Daniela Fabbri, Douglas Gale, Itay Goldstein, Arvind Krishnamurthy, Praveen Kumar, Nissan Langberg, Xuewen Lin, Martin Oehmke, Guillaume Plantin, Adriano Rampini, Jean-Charles Rochet, Jose Scheinkman, Raghu Sundaram, Alexei Tchistyi, Dimitri Vayanos, Jiang Wang, and an anonymous referee for useful discussions; to seminar participants at Bank of England, Brunel University, CEPR Symposium (2009) at Gerzensee, Chicago-GSB Conference on Liquidity Concepts, Duke, European Winter Finance Conference (2008) in Klosters, Federal Reserve Bank of New York conference on Liquidity Tools, University of Houston, Indian School of Business, London Business School, London School of Economics, University of Michigan, University of Minnesota, MIT (Sloan), NBER Research Meetings in Market Microstructure, New York Fed-NYU Conference on Financial Intermediation, Northwestern University, Oxford University, Princeton University, Southern Methodist University, Universite Toulouse, the Wharton School of the University of Pennsylvania and University College London for comments; and to Ramin Baghai, Wailin Yip, Or Shachar, and Yili Zhang for their research assistance. Brandon Lindley's help with numerical solutions was particularly helpful. Part of this paper was completed while Viral Acharya was at London Business School and while visiting Stanford-GSB. The usual disclaimer applies.


Financial firms raise short-term debt to finance asset purchases; this induces risk shifting when economic conditions worsen and limits their ability to roll over debt. Constrained firms de-lever by selling assets to lower-leverage firms. In turn, asset–market liquidity depends on the system-wide distribution of leverage, which is itself endogenous to future economic prospects. Good economic prospects yield cheaper short-term debt, inducing entry of higher-leverage firms. Consequently, adverse asset shocks in good times lead to greater de-leveraging and sudden drying up of market and funding liquidity.

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