The Paradox of Liquidity
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Transcript of The Paradox of Liquidity
The Paradox of Liquidity
Stewart C. MyersRaghuram G. Rajan
Presented by: Michael KeefeFebruary 13, 2007
FIN 7340 Corporate Theory II Dr. Nina Baranchuk
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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
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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
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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)
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The Order of Play
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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
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Date 1&1/2 Incentives
],min[ 22222
222
222
dddCV
ddCXdXdC
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.
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Date 1 Negotiation
Mngr InvOffer X Reject Naturea
(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
dVaCVL
LL
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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
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Maximum Debt the Manager can commit to repay
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Scenario I – Large C2 and P1
(9) & (10) do not bind (8) reduces to:
Note that d1 is greater than d2
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Date ½ Transformation Risk
Constraint (7)
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Financing Capacity ExampleIn-house
Project Firm Project Firm2Investment 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 1aC2+αd2 0.8 2.9 3.7 4.5α*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
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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
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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
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Manager Flexibility – Set Up
shortfallfinancing)db-d)C)(Cf(b,-(1project from flow cash reduced )C)(Cf(b,
b)db-d)C)(Cf(b,-(1-)C)(Cf(b, Max
Problem Managerbinds constraint tiontransforma Assume
debt external vs. investment personal of dollar a of Costlost flow cash of fraction0f with),f(b,
flow cash reducesy Flexibilit Managerof Loss - Assumptionmonitoring from after ManagerofLiquidity b
yFlexibilit Managerb
1221
21
122121
b
M
,
]1,0[
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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)
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Transformation RiskEntrenching 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
CCdC
dCdCash
0,1 whereflows cash asset unitdC
asset sellsManagerdasset new in invests and 1/2 at liquidates Manager
t
1
Results also hold when specific assets can be transformed
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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
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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
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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
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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.
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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