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THE PARADOX OF LIQUIDITY

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THE PARADOX OF LIQUIDITY*STEWART C. MYERS AND RAGHURAM G. RAJANThe more liquid a firm's assets, the greater their value in a short-notice liquidation. It is generallythought that a firm should find it easier to raise external finance against more liquid assets. Thispaper focuses on the dark side of liquidity: greater asset liquidity reduces the firm’s ability tocommit to a specific course of action. As a result, greater asset liquidity can, in some circumstances,reduce the firm’s capacity to raise external finance. Firms with [email protected] liquid assets are in thebest position to finance illiquid projects. This leads us to a theory of financial intermediation anddisintermediation based on the liquidity of assets. * Discussions with Phillipe Aghion, Franklin Allen, Sudipto Bhattacharya, Kent Daniel, DouglasDiamond, Paolo Fulghieri, Mark Gertler, Robert Gertner, Charles Kahn, Mitchell Petersen andRobert Vishny were very useful. We thank two anonymous referees and Andrei Shleifer forvaluable comments. Rajan acknowledges support from the National Science Foundation and theCenter for Research on Securities Prices at the Graduate School of Business, University of Chicago.The support of the Nobel Foundation in organizing a Symposium on Law and Finance where thispaper was presented is also acknowledged.For the first issue, see Diamond [1991], Hart and Moore [1994], Myers [1977], and Shleifer and Vishny 1[1992]. For the second, see Diamond and Dybvig [1986], Esty [1993], Flannery [1994], Huberman [1984], Kahn[1992] and an extensive literature on risk-shifting moral hazards, dating to Jensen and Meckling [1976].1I. INTRODUCTIONThe liquidity of an asset means the ease with which it can be traded. The more liquid a firm's assets,the greater their value in short-notice sales. Liquid assets are generally viewed as being easier to finance,other things equal. Asset liquidity is, therefore, often a plus for nonfinancial corporations or individualinvestors. For financial institutions, however, increased liquidity can paradoxically be bad. Although moreliquid assets increase the ability to raise cash on short notice, they also reduce management's ability tocommit credibly to an investment strategy that protects investors. The problem becomes more acute whenthe institution is in the business of making markets or trading for its own account.This paradox of liquidity can be seen in the following example. Consider a firm formed to makemarkets in government and corporate bonds. It starts with an inventory of liquid Treasury bonds. If thesesecurities could be irrevocably assigned as collateral to a lender, the company could finance its inventorywith almost 100 percent debt. But then the inventory would be locked up and of no use in trading.Such a firm cannot commit not to trade, and the liquidity of its assets opens up various tradingstrategies, many adverse to the lender. When it is essential for the firm to retain the flexibility to buy and sellassets, the firm may end up too liquid for its financiers’ comfort.A financial institution investing mainly in illiquid business could find long-term financing easier toarrange. Illiquidity means that creditors get less if they seize and sell the assets, but it increases the odds thatthe assets will "be there," and gives creditors more time to assess their values and risks. In short, liquid assetsgive creditors greater value in liquidation, but they also give borrowers more freedom to act at creditors'expense. While both issues have been separately recognized, their interactions are largely unexplored. 1We show that a firm which starts with liquid core assets has an absolute advantage in obtainingexternal finance for less liquid projects. The incremental external financing the firm generates by taking onthe less liquid project exceeds the financing the project can obtain on its own.2Firms with relatively liquid core businesses are then best suited to channel financing to other firmsin the economy. This leads to a theory of financial intermediation which is consistent with the historicalorigins of the rise of banks -- that banks started by providing payment services and only later moved tolending. Our theory can also explain why disintermediation -- in which the most creditworthy firms bypassbanks to borrow directly from the markets -- has increased recently.Our essential point is quite general. A manager, by virtue of her operational control, has implicitproperty rights in the firm. Greater asset liquidity enables her to transform assets so as to alter the distributionof implicit property rights in her own favor. At the same time, greater asset liquidity improves a financier’sability to exercise control over the manager and thus enhances his property rights. As a result, greater assetliquidity increases the potential for conflict between the manager and the financier over property rights. Thisis ultimately resolved by limiting the manager’s operational flexibility (and potentially reducing the firm’soutput), limiting the financier’s control rights (and hence reducing financing), or altering the assets that areheld together in the firm. The rest of the paper is as follows. In Section II, we first catalog the various meanings andimplications of "liquidity" from the manager and financier's points of view. These depend, for example, onthe financier’s legal and contractual rights, on the manager's need for flexibility in the sale or use of assets,and on whether the firm is transparent or opaque to outsiders. Then we analyze a simple model illustratingthe paradox of liquidity and the determinants of external financing. In Section III, we consider whether thesimple model is robust and consistent with optimal contracting. Section IV works out the conditions underwhich financing is done more efficiently via financial intermediaries. We consider the historical emergenceof banks and general implications for the roles of financial markets and intermediaries. We conclude withpolicy conjectures and suggestions for future research.II. THE BASIC MODELA. FrameworkOf course a positive d implies subsequent cash flows. We could keep track of one more cash flow22C , for example. But we assume d = 0, so that the investor has no bargaining power after date 2. Thus3 3we can stick to a two-period model. The former action is, in fact, equivalent to the financier holding a controlling outside equity stake in the firm3because the financier retains the right


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