Leverage, Moral Hazard, and Liquidity

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Abstract
Financial firms raise short‐term debt to finance asset purchases; this induces risk shifting when economic conditions worsen and limits their ability to roll over debt. Constrained firms de‐lever by selling assets to lower‐leverage firms. In turn, asset–market liquidity depends on the system‐wide distribution of leverage, which is itself endogenous to future economic prospects. Good economic prospects yield cheaper short‐term debt, inducing entry of higher‐leverage firms. Consequently, adverse asset shocks in good times lead to greater de‐leveraging and sudden drying up of market and funding liquidity.

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