Leverage, Moral Hazard and Liquidity

51 Pages Posted: 8 Feb 2010 Last revised: 10 Sep 2013

See all articles by Viral V. Acharya

Viral V. Acharya

New York University - Leonard N. Stern School of Business; New York University (NYU) - Department of Finance; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI); National Bureau of Economic Research (NBER)

S. Viswanathan

Duke University - Fuqua School of Business; Duke University - Department of Economics

Multiple version iconThere are 3 versions of this paper

Date Written: January 2010

Abstract

We consider a moral hazard setup wherein leveraged firms have incentives to take on excessive risks and are thus rationed when they attempt to roll over debt. Firms can sell assets to alleviate rationing. Liquidated assets are purchased by non-rationed firms but their borrowing capacity is also limited by the risk-taking moral hazard. The market-clearing price exhibits cash-in-the-market pricing and depends on the entire distribution of leverage (debt to be rolled over) in the economy. This distribution of leverage, and its form as roll-over debt, are derived as endogenous outcomes with eachfirm's choice of leverage affecting the difficulty of otherfirms in rolling over debt in future. The model provides an agency-theoretic linkage between market liquidity and funding liquidity and formalizes the de-leveraging offinancial institutions observed during crises. It also explains the role played by system-wide leverage in generating deep discounts in prices when adverse asset-quality shocks materialize in good times.

Suggested Citation

Acharya, Viral V. and Viswanathan, S., Leverage, Moral Hazard and Liquidity (January 2010). NYU Working Paper No. 2451/29544, Available at SSRN: https://ssrn.com/abstract=1548819

Viral V. Acharya (Contact Author)

New York University - Leonard N. Stern School of Business ( email )

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Suite 9-160
New York, NY NY 10012
United States

HOME PAGE: http://pages.stern.nyu.edu/~sternfin/vacharya/public_html/~vacharya.htm

New York University (NYU) - Department of Finance

Stern School of Business
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New York, NY 10012-1126
United States

Centre for Economic Policy Research (CEPR)

London
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European Corporate Governance Institute (ECGI) ( email )

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Belgium

National Bureau of Economic Research (NBER)

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S. Viswanathan

Duke University - Fuqua School of Business ( email )

Durham, NC 27708-0120
United States
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919-684-2818 (Fax)

Duke University - Department of Economics

213 Social Sciences Building
Box 90097
Durham, NC 27708-0204
United States

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