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Inside and Outside Liquidity

Inside and Outside Liquidity

Bengt Holmström
Jean Tirole
Copyright Date: 2011
Published by: MIT Press
Pages: 264
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  • Book Info
    Inside and Outside Liquidity
    Book Description:

    Why do financial institutions, industrial companies, and households hold low-yielding money balances, Treasury bills, and other liquid assets? When and to what extent can the state and international financial markets make up for a shortage of liquid assets, allowing agents to save and share risk more effectively? These questions are at the center of all financial crises, including the current global one. In Inside and Outside Liquidity, leading economists Bengt Holmström and Jean Tirole offer an original, unified perspective on these questions. In a slight, but important, departure from the standard theory of finance, they show how imperfect pledgeability of corporate income leads to a demand for as well as a shortage of liquidity with interesting implications for the pricing of assets, investment decisions, and liquidity management. The government has an active role to play in improving risk-sharing between consumers with limited commitment power and firms dealing with the high costs of potential liquidity shortages. In this perspective, private risk-sharing is always imperfect and may lead to financial crises that can be alleviated through government interventions.

    eISBN: 978-0-262-29553-6
    Subjects: Finance

Table of Contents

  1. Front Matter
    (pp. i-iv)
  2. Table of Contents
    (pp. v-vi)
  3. Acknowledgments
    (pp. vii-viii)
  4. Prologue: Motivation and Roadmap
    (pp. 1-8)

    Why do financial institutions, industrial companies and households hold low-yielding money balances, Treasury bills, and other short-term assets? The standard answer to this question, dating back at least to Keynes (1936), Hicks (1967), and Gurley and Shaw (1960), is that these assets are “liquid” as they allow their owners to better weather income shortages.¹

    It is unclear, though, why an economic agent’s ability to withstand shocks would not be better served by the broader concept of net wealth, including stocks and long-term bonds. While some forms of equity, such as private equity, may not be readily sold at a “fair...

  5. I Basics of Leverage and Liquidity

    • [I Introduction]
      (pp. 9-14)

      In standard microeconomic theory a firm that confronts financial needs can meet these needs as they arise by taking out loans or by issuing new securities whose repayments and returns are secured by the cash flows that the firm generates. As long as the net present value of a reinvestment is positive, investors will agree to supply the needed funds.¹ Reality is very different. Firms keep a close watch on their current and forecasted cash positions to ensure that their essential liquidity needs can be met at all times. They do not wait until the cash register is empty. To...

    • 1 Leverage
      (pp. 15-26)

      We use a very simple model of credit rationing as the basic building block for our liquidity analysis. An entrepreneurial firm has an investment opportunity with a known outcome, but only part of the return is pledgeable to investors. When the pledgeable income is insufficient to cover the full investment cost, the firm has to cover the gap with funds it has accumulated from the past. As a result the firm’s investment is constrained by the firm’s net worth (unlike in classic theory). We start with a version of the model where the investment scale is fixed. We then introduce...

    • 2 A Simple Model of Liquidity Demand
      (pp. 27-60)

      Firms demand liquidity in anticipation of future financing needs either because it is cheaper to get financing now or because there is a risk that financing will not be available if the firm waits until the need for funding arises. In this chapter we analyze the demand for liquidity in a simple extension of the two-period model from section 1.3. The basic idea is easy to understand. Suppose that there is an intermediate period when additional funds have to be invested in order to continue the project and realize any payoffs. We refer to this reinvestment need as aliquidity...

  6. II Complete Markets

    • [II Introduction]
      (pp. 61-64)

      Much of the agency-based modeling of corporate finance focuses on the problem of raising funds for investment when investors worry that they may not get their money back. The model in chapter 2 is one such example, illustrating the constraints and distortions stemming from concerns over a firm’s credibility. Much less attention has been paid to the converse credibility problem: ensuring that the suppliers of liquidity—the lenders, insurers and other investors who explicitly or implicitly commit to fund a firm in the future—will be able to deliver on their promises.¹

      This issue shows up starkly in the model...

    • 3 Aggregate Liquidity Shortages and Liquidity Premia
      (pp. 65-88)

      The key observation we made above is that the very problem that leads to ademandfor liquidity, namely a wedge between pledgeable and nonpledgeable income, also limits thesupplyof inside liquidity. Insurance within the corporate sector depends on claims issued by the corporate sector. If firms have no pledgeable income, there are no corporate claims and therefore no inside liquidity to back up promises of funding or insurance. At the other extreme, if all corporate income is pledgeable (as in the Arrow–Debreu model), there is no need for insurance, since all continuation decisions are self-financing and therefore...

    • 4 A Liquidity Asset Pricing Model (LAPM)
      (pp. 89-114)

      In this chapter we extend the simple model from the previous chapter to a general liquidity asset pricing model (LAPM) with heterogeneous firms employing linear technologies of the sort we have been studying. Uncertainty can affect all the parameters of these technologies. The model shows how liquidity premia are determined in such a setting, how they affect bond yields and firm values, and how firms plan investments and optimally manage liquidity risks in light of such premia. We start with the case where there are two aggregate shocks, before moving on to the general model.

      For heterogeneous firms it is...

  7. III Public Provision of Liquidity

    • [III Introduction]
      (pp. 115-120)

      Chapter 3 demonstrated that the wedge between total returns and pledgeable returns on investments can create a shortage of instruments for transferring wealth from one period to the next and thereby make it more costly, or even impossible, for firms to insure against future liquidity shocks through credit lines or other forms of advance funding. In the language of the book’s title, there may be a shortage of inside liquidity (corporate-backed claims) in some states of nature. This impairs the insurance market between consumers and entrepreneurs. While the consumers have the income needed to make insurance payments at date 1,...

    • 5 Public Provision of Liquidity in a Closed Economy
      (pp. 121-144)

      As we discussed in the introduction above, consumers’ future labor income by and large cannot be pledged to the corporate sector. Yet firms do face shortages of pledgeable income in bad states of nature, and transfers to the corporate sector can therefore be Pareto improving (provided that opposite transfers are made in good states of nature). When there is a missing insurance contract between consumers and firms, the state, through its power to tax, can in part make up for this missing contract. This is the very rationale behind countercyclical policies.

      This chapter studies the nature of the missing insurance...

    • 6 Liquidity Provision with Access to Global Capital Markets
      (pp. 145-164)

      In this chapter we study an economy with free access to global financial and goods markets. We have two objectives in mind with this extension. The first is to suggest that the model we have developed, appropriately extended to an international context, can offer a useful perspective on worldwide events such as the 1990s financial crises in Thailand and Mexico and the current concerns about global imbalances. Our second, closely related objective is to address a conceptual question of great relevance for our study: How can a shortage of savings/insurance instruments in a small country like Thailand play a significant...

  8. IV Waste of Liquidity and Public Policy

    • [IV Introduction]
      (pp. 165-168)

      In our study of aggregate liquidity shortages, we have assumed that the corporate sector can make efficient use of liquidity in each state of nature at date 1. One way in which efficient use of liquidity can be assured is to have a complete market of state-contingent claims on pledgeable income available for trade at date 0. This was illustrated by the LAPM model of chapter 4. As we discussed earlier, there may be many institutional solutions that achieve the same outcome, but our model is not rich enough to distinguish among them. In the real world, banks, conglomerates, and...

    • 7 Financial Muscle and Overhoarding of Liquidity
      (pp. 169-198)

      We have so far assumed that the corporate sector makes efficient use of existing liquidity; that is, firms coordinate their liquidity provision through the pooling of liquid assets and the use of credit lines and other institutions that in effect dispatch available liquidity to those firms that need it most. This chapter and the next analyse situations in which firms fail to achieve such coordination. Rather, firms hoard liquid assets on their own balance sheet or count on the resale of relatively illiquid assets in the secondary market to meet their liquidity shocks.

      This chapter explores the reasons why firms...

    • 8 Specialized Inputs and Secondary Markets
      (pp. 199-226)

      In this chapter we continue to analyze the implications of firms relying exclusively on secondary markets for their liquidity needs. As in the previous chapter we assume that firms do not coordinate their balance sheet choices and that there are no aggregate shocks. Firms hoard an input, which we will call a “widget.” This input is needed to keep long-term assets operative. A widget is a generic term that can stand for many things. It could literally be a mechanical part that is needed for continuing production, it could be a service or knowledge that is needed to make the...

  9. Epilogue: Summary and Concluding Thoughts on the Subprime Crisis
    (pp. 227-242)

    We started our research on liquidity over fifteen years ago with the aim of understanding the role of liquidity (collateral) shortages in financial crises.¹ We close this book with some reflections on what our approach can tell us about the ongoing subprime crisis. We begin by summarizing the key themes and insights of the book, before getting into the crisis itself.

    Our approach is based on two key premises. The first is that income streams are not fully pledgeable.² Only part of the pie that a firm creates can be credibly pledged to investors,³ and consumers cannot pledge any of...

  10. Bibliography
    (pp. 243-250)
  11. Index
    (pp. 251-254)