INSIDE AND OUTSIDE LIQUIDITY by Bengt Holmstrom (based on joint work with Jean Tirole)

February 2008

INTRODUCTION

Background: Micro: demand for liquidity, risk management, asset pricing Macro: supply of liquidity, financial crises, liquidity management Basic questions: Do claims on corporate assets provide sufficient liquidity for an efficient functioning of the productive sector? What role, if any, should the government play in supplying and managing liquidity? How does access to international financial markets affect aggregate liquidity constraints?

Underlying premise: All financial claims must be backed by real (non-human) assets No other exogenous restrictions on financial claims

WHY DO FIRMS DEMAND LIQUIDITY?

Demand for liquidity = Demand for long-term financial instruments No corporate demand for liquidity: in standard theory --- firms can finance all positive net present value projects on an as-needed basis in standard liquidity approach (Diamond-Dybvig)

Key ingredient: the full value of a firm cannot be promised to outside investors (z1 > z0)

pledgable 0 z0

non-pledgable z1

Three reasons why z1 > z0: Adverse selection (eg. liquidity traders lose to informed traders) Moral hazard (eg. entrepreneur has to be given incentives not to steal or to put out proper effort) Search costs Firms want ex ante insurance against shocks to liquidity

OUTLINE OF TALK

Demand for liquidity Credit rationing Liquidity shocks

Private supply of liquidity Liquidity shortages Endogenous supply of liquidity Liquidity premia and asset pricing Government supply of liquidity Government bonds State-contingent bonds International liquidity International vs domestic collateral

CREDIT RATIONING

(z1 z0)I external I z1 I z0I internal

Assume:

z0 < 1 < z 1

Program:

= max (z1 z0)I I zoI I A

A 1- z0

s.t.

Solution:

I =

U =

A (z1 z 0 ) > A (1 z 0 )

DEMAND FOR LIQUIDITY

Add liquidity shocks: z = zL or zH (for simplicity only two outcomes)

contract

shock z

continue zi(z) liquidate

(z1 z0)i(z)

0
Assume:

zL < z0 < 1 < z H < z1 max (z1 z0) (pL + pHx) I x,I s.t. pL(z0 zL)I + pHx(z0 zH)I I A
> 0 < 0

Program:

Negative NPV in H-state all insurance has that feature

SECOND-BEST SOLUTION

Investment:

A I = 1 p (z z ) p x(z z ) L 0 L H 0 H

Reinvestment:

x = 1 if and only if pL(zH zL) 1

Note:

Ix=0 > Ix=1 zL 0 z0 1 zH z1

Continuous distribution F(z): z* 0

z*

z0

1
Discontinue

z1

F( z )dz
0

=1

z1 - z * U = z* z A 0

Credit rationing at date 0 and date 1.

THE SUPPLY PROBLEM Equilibrium model: Single non-storable good (corn) Individual preferences: c0 + c1 + c2; suffiently large endowments Many firms with identical (two-state), CRS technologies

Key constraint: consumers cannot borrow against future endowment (financial commitments have to be backed by real assets)

How can liquidity shocks be financed? Issue new securities at date 1 (initial shareholders are junior) Buy securities in other firms at date 0 and sell at date 1

Pure aggregate shock: only self-financing possible. Can raise up to z0I in new funds at date 1. self-financing works if doesnt work if 0 zL Self-financing z0 z = zL < z0 z = zH > z0 zH External financing z1

COORDINATING LIQUIDITY DEMAND

Independent shocks: Demand: Supply: pH (zH z0) I pL (z0 zL) I Yes, because:

Supply > Demand ?

pL (z0 zL) I + pH (z0 zH) I I A > 0 However: Market instruments may not suffice. Compare date-1 value of share in market index (after refinancing) with liquidity demand by firm with high liquidity shock: S = z0 pH zH pL zL zH z0 For small enough z0 this condition is violated. Problem: Firms with low liquidity shock are wasting scarce liquidity. Solution: Intermediation

INTERMEDIATION

Intermediary can eliminate waste by coordinating liquidity demand by firms. Market index is worth S = z0 pH zH pL zL> I A > 0 so there is enough aggregate liquidity. Intermediary Issues shares to consumers at date 0 Invests proceeds in market index (buys all public claims on the corporate sector) Issues credit lines to firms. Allows each firm to draw up to zH I at date 1. Result Assuming firms have no other use for funds, they will draw zH or zL according to need. By investing in market index at date 0, credit lines fully backed by claims on productive assets. Intermediation cross-subsidizes firms with high liquidity shocks (who end up with negative NPV reinvestments). To work, credit lines must have commitment fees. Intermediation provides insurance a la Diamond-Dybvig (but with markets playing a positive role). Liquidity supply the two questions: Is there enough aggregate pledgable income in each state? Is the financial system making optimal use of it?

ENDOGENOUS LIQUIDITY SUPPLY Pure aggregate shock: all firms experience either high liquidity demand zH or low liquidity demand zL. Add a storage technology (a short-term technology). Cost of production (could come from govt supply): i0 = C(LS) Date 0 cost of producing LS units of date 1 good is i0. Storage is risk free. Let q 1 be the date-0 price of one unit of pledgable date-1 corn (= date-1 liquidity). Firms budget constraint becomes: pL (z0 zL) I + pH (z0 zH)xI (I A) + (q 1)(zH r)xI The firms demand function:

D(q) = x(q)I(q)(zH z0) =

0, for q > qmax I(q)(zH z0), for q < qmax (x in (0,1) for q = qmax)

Supply function LS(q) q = C(LS(q))

Equilibrium with liquidity premium

qmax

LS

qE > 1 q=1

LD

LE

Equilibrium characterized by: liquidity premium qE 1 > 0, when there is a shortage of liquidity only firms buy claims on storage technology efficiency Example of endogenous supply: mortage backed securities = increasing z0 through monitoring (net increase depends on what funds spent on)

EMPIRICAL EVIDENCE OF SCARCE SUPPLY Krishnamurthy&Jorgense-Vissing 2007

GOVERNMENT BONDS

Assume: Government can commit funds on behalf of consumers by virtue of taxation right. Can make inter-generational transfers. Bond: Date-0 price q 1 Date-1 price =1

If q = 1, then firms can implement second-best: Reduces date-0 investment Reduces date-1 liquidation Aggregate investment goes up Value of firms go up Liquidity premium (q > 1) to cover deadweight loss of taxation: Only firms buy government bonds Lower aggregate investment Bias towards ex ante investment (and more generally towards investments that fetch liquidity premium; shorter investment horizons to build up liquidity stock) Free-riding: Resolution: state-contingent bonds.

STATE-CONTINGENT BONDS When z = zL, firms will cash government bonds even though they dont need liquidity. Wasteful taxation. More efficient to use state-contingent bond: z = zL z = zH bond pays 0 bond pays 1

Lower liquidity premium, since dead-weight loss smaller More efficient than having private sector create real assets Key feature: Transfers income from consumers to producers Interpretations: Monetary policy; lower interest rate increases value of bond. Requires dynamic model. Discount window (??) YK2 put options (insurance markets) Many other ways government creates liquidity (eg unemployment insurance) A metaphor for any active government policy that transfers wealth from consumers to producers. What about taxing consumers in recession? Depends on nature of shocks. Need to look at consumer and producer demand for liquidity.

FACTORS AFFECTING AGGREGATE LIQUDITY --- MONITORING BY INTERMEDIARY

Without monitoring: external 0 r internal R

With monitoring: external 0 z0 monitor internal zm z1

Monitor can restrict misbehavior or extract more out of entrepreneur than general market (Holmstrom-Tirole QJE 97; Diamond-Rajan JPE) Monitoring allows financing of marginal firms. Well capitalized firms and firms with marketable assets will not need monitor. Monitoring incentives require monitor to invest capital (could be reputation). When capital scarcity increases, marginal firms will be excluded (flight to quality).

FACTORS AFFECTING AGGREGATE LIQUIDITY --- OPPORTUNISM

Ex post opportunism: Entrepreneur can divert unused credit line for own private benefit (eg consumption) Extreme case: divert all of it for own consumption Non-discretionary credit line Limited dilution of initial claims Dilution contingent on aggregate shock only

Demand for active monitoring of credit use

ASSET LIQUIDATION AND MARKET SOFTNESS

t=0

t=1

t=2

(z1 z0)(IL)

Liquidate L Proceeds v(L)L Problem: Uncoordinated liquidation may lead to market collapse Example: v, v(L) = 0, Assume L* <
A and zL = 0. 1 z0

if L L* if L > L*

Two possible equilibria: (1) Invest

A ; liquidate if z = zH. 1 z0

(2)

A Invest 1 r + p xz ; liquidate fraction (1 x): H H

zHx = v(1 x) Eqm (2) is preferred, but will require coordination. Coordinated investment and liquidation removes liquidity demand Positive externalities also possible (Shleifer-Vishny)

ASSET PRICING (LAPM)

Pure aggregate uncertainty. Additional assets with exogenous payoffs k. Normalize: E(k) = 1, for each k. qk -- price of asset k at date 0 Lk -- supply of asset k Budget constraint of corporate sector:

i E0(z0i zix(zi))Ii + k Lk > i (Ii Ai) + k qkLk

qk 1 = E0(k| H)sHpH

sH -- shadow price of liquidity in state H

q k 1 E 0 ( k | H ) = q l 1 E 0 ( l | H )

Co-movements Skewed risk tolerance Most efficient asset pays only in state H

International insurance with identical rms

Three periods, t = 0, 1, 2. Goods and preferences. Tradable goods (dollar goods) consumed by foreigners as well as domestics. Variables referring to dollars are starred Nontradable goods (peso goods) consumed only by domestics. Pesos are used as numeraire. Preferences.

Foreigners utility from the consumption stream {c t }t=0,1,2

2 X t=0

c t,

Domesticsutility from the consumption stream {(c t , ct )}t=0,1,2

2 X t=0

[c t + ct ] .

State of nature (revealed at date 1). Price of a peso delivered at date 1 s( )f (). Price of dollar delivered at date 1 s ()f ( ) Date-0 real exchange rate, e, (peso price of a dollar),. Date-1 exchange rate e1 is s ()/s( ). In equilibrium, e, e1 1.

 Firms and technologies. Unit mass of rms (=entrepreneurs). Peso endowment A, dollar endowment A . External supply of date-1 peso goods L and dollar goods L (eg supplied by government) Date 0: Firms invest I , I . Date 1: Conditional on the realized state of nature , rms make reinvestments i( ) and i ( ), costing z ( ), z ( ). ( ) as well as the total payo Date 2: Pledgeable payos z0 () and z0 z1 ( ), are realized. The non-pledgable private benet z1 () z0 ( ) z0 () is always strictly positive. Collateral.

International collateral z0 () Domestic collateral z0 () + z0 ().

Foreign investors can secure pledges at no cost using collateral on international markets. When domestic dollar assets are scarce, there is a peso premium on international collateral.

 Equilibrium. The representative rm chooses its production plan (initial investments and continuation decisions) to solve the following program:
( )) Max E (Z1 ( ) Z0 () Z0

(I A) + e(I A ) + E [l( )s( ) + l ( )s ()] 0. Z0 ( ) Z ( ) + l( ) + t ( ) 0, for every

Z0 ( ) Z () + l () t ( ) 0, for every

(1) (2) (3) (4)

(i( ), i ( )) D(I, I ) and t ( ) 0.

Two equilibrium conditions, determine the price of dollar goods at dates 0 and 1. Peso liquidity in state (gives s( )): l ( ) L(), for every , with s( ) = 1 if constraint is slack. (5)

Date-0 zero dollar market clearing (gives e): I + E l () A + E L ( ), . with e = 1 if constraint is slack. Note: e = s () 1 for every . e = s ( ) s( ) 1. (7) (8) (6)

1.1

Example 1: All output tradable

Entrepeneurs endowment A > 0, A = 0..Date 0 investment I . Date 1, reinvestment zi(z ), i(z ) I Date 2 output all in dollars z0 i(z ) with private benet (z1 z0 )i(z ). Since all pledgable output in dollars, theres no liquidity shortage (rm can buy insurance on international markets). e = s (z ) = s(z ) = 1. Firm solves I and {i(z )} by
)i(z )]} max {Ez [(z1 z0 s.t. z )i(z )], (i) I A Ez [(z0

(9)

(10)

(ii) 0 i(z ) I, for all z. Optimal continuation rule: i(z ) = I if z z and i = 0 otherwise, where optimal cut-o z satises
z0 <z < z1 .

(11)

Two points: If a small open economy has enough export income, international markets eliminate all problems of domestic liquidity shortage. Firms choose incomplete insurance (z < z1 ) even though international markets oer insurance on actuarially fair terms. Financial crises are part of an optimal insurance plan even in the most favorable of circumstances.

1.2

Example 2: Tradable and non-tradable outputs

In Example 1, no role for government supplied liquidity, because international investors willing to supply liquidity at zero premium. When a countrys international collateral is scarce, theres a role for government supplied domestic liquidity. All investments still in pesos. In addition to pledgeable dollar output z0 i(z ) there is now pledgeable peso output z0 i(z ). Entrepreneur has endowments A and A Government supplies L units of one-period dollar bonds and L units of peso bonds at date 0. Firm chooses I and i(z ) to solve
)i(z )]} max {Ez [(z1 z0 z0 s.t. (i) (I A) + e(I A ) + Ez [l(z )s(z ) + l (z )s (z )] 0,

(12)

(iia) (z0 z )i(z ) + l(z ) + t (z ) 0,

(iib) z0 i(z ) + l (z ) t (z ) 0,

for all z

for all z.

(iii)

0 i(z ) I and t (z ) 0 for all z .

Equilibrium prices are determined by l(z ) L, and I + Ez [l (z )] A + L , with equality whenever e > 1. for every z with equality whenever s(z ) > 1.

Dem and for liquidity

zi ( z )

L + L*

International Liquidity

L
Domestic Liquidity

z * z0

z z0

( z z0 )

When dollars scarce relative to pesos e = s (z ) > s(z ) 1.The optimal solution is characterized by ve regions encountered in order as z increases: (i) (ii) (iii) (iv) (v) i(z ) = I , zI L, t (z ) = 0 i(z ) = I, L < zI < L + L , t (z ) > 0 i(z ) < I, zi(z ) = L + L , t = L . i(z ) < I, zi(z ) = L, t = 0 i(z ) = 0

When the liquidity shock z can be met with pesos, the rm will do so. Dollars are scarce and will be used only in states z where shock exceeds available peso liquidity. Price of dollars (e > 1) will not vary with the state, because international insurance markets have no liquidity constraints. The price of peso liquidity will vary, because of state-contingent liquidity constraints: s(z ) = 1, in unconstrained states and s(z ) = s (z ) = e > 1 in constrained states. International nancial markets will alleviate, but not remove need for domestic liquidity management. 6

CONCLUSIONS
Simple framework for studying supply and demand of liquidity by firms. Supply of liquidity determined by two factors: o Aggregate liquidity = total value of productive goods and services (in each state); base for contracting o Optimal coordination of liquidity = state-contingent use of liquidity; waste of liquidity Corporate governance and intermediation affect both pledgable income (aggregate liquidity) and waste of liquidity Capital poor countries: small base and suboptimal use of it Government can act as intermediary between consumers and corporate sector: insurance by transferring wealth Many forms of government insurance: monetary policy, unemployment insurance, devaluations, etc. International financial markets can provide insurance to the extent country has international collateral. Government as well as international insurance in states with liquidity shortage. Undersupply of international insurance if aggregate liquidity imperfectly coordinated.