The Paradox of Liquidity

Stewart C. MyersRaghuram G. Rajan

Presented by: Michael KeefeFebruary 13, 2007

FIN 7340 Corporate Theory II Dr. Nina Baranchuk

2

External Financing and Liquidity

Tension Illiquidity => creditors get less if seize and sell

assets Illiquidity => higher probability assets will be there

Greater Liquidity increases conflict over property rights of asset

3

Model Set-Up The Players

Investor - Principal Manager/Owner – Agent

Assumptions Manager has positive $1 NPV project 2 period model with renegotiation Cash Flows C1 and C2 are generated at dates 1 and 2 respectively Project requires purchase and use of asset with replacement cost of d1 and d2 at dates

1 and 2 respectively $1 NPV => Investment-(C1 + C2 + d2) > 1 Assume C2 + d2 >= d1 Index of Liquidity α (i.e. can liquidate for αd)

Information and Contracts C1 and C2 not observable by Investor Contractual Variables

Ownership of Asset => right to choose who operates or sell asset Cash Paid by Manager to Investor can be verified and contracted on

Manager can not operate asset efficiently

4

Liquidity and Transformation Risk

Investor Worries Manager Steals Asset (e.g. commodities) Sell asset and take cash (payoff proportional to liquidity) Transform to assets specific to manager expertise Substitute with risky assets (shift value from debt to equity)

Nature of Liquidity Initial Assumption αm=α

Efficient legal system => αm<α Trader => high transformation risk due to opaque

environment (complex positions not easily monitored)

5

The Order of Play

6

Date 2 Negotiation

Mngr Inv

MngrPay

NotPay

Offer X

Accept

Reject

(Manager, Investor)

(C2+d2-X, X)

(C2+d2-P2,P2)

(C2, αd2)

Result – Manager offers min[P2,αd2]Note – Manager and Investor both KNOW α, d2, and P2

7

Date 1&1/2 Incentives

],min[ 22222

222

222

dddCV

ddCX

dXdC

L

Mngr

Transform

Continue

(αd2,0)

(C2+d2-min[αd2,P2], min[αd2,P2])

(Manager, Investor)

It is in the incentive of investor to insure the Manager continues.

8

Date 1 Negotiation

Mngr InvOffer X Reject Nature

a

(1-a)

Inv

Mngr

Take

Leave

Take

Leave

Mngr

Inv

Nature acts w.p. a investor makes offer & w.p. (1-a)manager makes offer

1. Given bargaining power investor or manager will each make take it or leave it offer (Demand C2)

1.

1.

Yes

No

Yes

No

Since investor can force liquidation at Date 1, the value to Lender is:

1222221

1221

],,min[max

],max[

ddddCaCV

dVaCV

L

LL

9

Date ½ Incentives

Manager can transform asset and receive αd1

The Manager can commit to not transform assets only if:

The Investor will only offer financing at date 0 if:

12/1221 dVdCC L

*2

*12/1 PPBV L

10

Maximum Debt the Manager can commit to repay

11

Scenario I – Large C2 and P1

(9) & (10) do not bind (8) reduces to:

Note that d1 is greater than d2

12

Date ½ Transformation Risk

Constraint (7)

13

Financing Capacity Example

In-houseProject Firm Project Firm2

Investment 2 5 7 5Cash Flow 1 (C2) 1 1 2 1Date 1 Liquidating Value (d1) 2 5 7 5Cash Flow 2 (C2) 1 1 2 1Date 2 Liquidating Value (d2) 1 4 5 4Liquidity α 0.3 0.6 1Bargaining prob a 0.5 0.5 0.5NPV 1 1 2 1C1+C2+d2-αd1 2.4 3 5.4 1

aC2+αd2 0.8 2.9 3.7 4.5

α*d1 0.6 3 3.6 5max[aC2+αd2,α*d1] 0.8 3 3.7 3Project - Debt capacity of .8 (Illiquid Project)Firm - Debt Capacity is 3 (low cash, high α, high d2)In-house - Debt Capacity of 3.7 is less than sum of 3.8Firm2 - α is 1 => Debt Capacity shrinks to 1

14

Financing Capacity

Assumption – Assets of a firm can not be transformed or liquidated seperately

Constraints bind over three possible ranges of liquidity (a) Illiquid – Debt determined by cash flows and final liquidation (b) Liquid – Debt determined by liquidation value of assets (c) Overly Liquid – Debt capacity reduced by excessive liquidity

Ranges

15

16

Robustness Equity – Manager can beat investor to

transformation Investor has unconditional ownership and not conditional

on default Investor pays salary (assume large enough to cause

default and start negotiation process) If (7) binds manager will tranform

Transformation incentive of manager reduced when illiquid projects added (way to check transformation risk)

Endogeneity – Manager gives up transformation ability to get more internal financing

17

Manager Flexibility – Set Up

shortfallfinancing)db-d)C)(Cf(b,-(1

project from flow cash reduced )C)(Cf(b,

b

)db-d)C)(Cf(b,-(1-)C)(Cf(b, Max

Problem Manager

binds constraint tiontransforma Assume

debt external vs. investment personal of dollar a of Cost

lost flow cash of fraction0f with),f(b,

flow cash reducesy Flexibilit Managerof Loss - Assumption

monitoring from after ManagerofLiquidity b

yFlexibilit Managerb

1221

21

122121

b

M

,

]1,0[

18

Endogeneity Findings

If f is concave in b, the b* is increases with cash flow decreases with θ decreases with the date 1 value of assets (less opportunity

for transformation with small d1)

Relationship between optimal flexibility and liquidity depends on fb,α fb,α small then db*/dα negative (buy and hold assets)

fb,α large then db*/dα decreases (e.g. trader requires more flexibility)

19

Transformation Risk

Entrenching Investment – Manager can substitute general purpose assets into specific assets - Shleifer and Vishny (1989)

221*2

*1

211

2

1

11

1

)1(221 dCaCdCCPP

CCd

C

d

CdCash

0,1 whereflows cash asset unitd

C

asset sellsManagerd

asset new in invests and 1/2 at liquidates Manager

t

1

Results also hold when specific assets can be transformed

20

Banking Banks originated in middle ages as money changers

due to quality issues with coins. (DeRoover 1948) Kept 30% of deposits as reserves Laws focussed on preventing fraud Riu(1979)

Governments formed banks Transformation risk endured (war, fiscal distress) 100% reserves and still defaults

Why did the government banks not put the private banks out of business? Municipal kept 100% in liquid asset reserves => temptation

for municipality to raid Illiliquid loans and investments of money changer served to

bind the liquid assets of the money changer

21

Banks Today

Assets – Mix of illiquid loans and liquid securities

Liabilities – Short Term Deposits Model to Banking

For banks to serve demand depositors => need liquidity; however scale will not solve transformation issue

Banks make illiquid loans to increase debt capacity

22

Bank Model Set-Up

payments individual than higher are payments Bank aa since

capacity debt funded Bank PdCa

capacity debt fundedly Individual PdCa

aa

Individual of power bargaininga

Firm of power bargaininga

ryIntermediaBank

PI

PF

F22

FI

P22

PI

PI

PF

PI

PF

Approach & Findings• Evaluates recourse of individual investors if bank misses payment Individual investor gets reduced payoff• Implication is that intermediation may not dominate direct lending

23

Contrasting Theories

Diamond and Dybvig (1993) – Banks exist to so consumer can fund uneven consumption and fund projects

Calamiris and Kahn (1991) – First come first serve nature of banks incent depositors to monitor

Transformation risk of banks is increasing due to technology=>hard for banks to make loans to most credit worthy accounts M&M world – A credit rated bank could make loan to AAA

company and get correct return Model – Transformation risk does not allow loan to fall to

cost of capital of that loan.

24

Conclusions

Transformation Risk => Debt Capacity is not monotonic in the intrinsic liquidity of assets

Assets in an overly-liquid firm can not be used as collateral for debt => debt capacity is increased by taking on less liquid projects