How Does Liquidity Risk Disturb Asset Prices? : A General Equilibrium Approach

Liquidity risk was conspicuous in the recent financial market turbulence. This paper presents a liquidity risk model in which two financial institutions trade an illiquid risky asset. The model develops explicit liquidity demand and supply curves along with analytical solutions, and it inherently generates two types of general equilibrium – liquid and illiquid. Liquidity risk manifests in the illiquid equilibrium to depress the asset price to deviate from the fundamental value. In turn, the model shows that riskier assets have thinner liquidity supply and heavier liquidity demand. The model is able to analyze precautionary hoarding, runs on financial institutions, and loss spiral. The model suggests that hoarding liquidity in turmoil is an effective way for a financial institution to earn profit and also maintain a solid financial condition. Bank-run is an important externality of deteriorating market condition caused by hoarding. It can motivate financial institutions to hoard less liquidity. Lastly, financial institutions should be relieved from marking-to-market to prevent loss spiral, as it may lead to illiquidity and, eventually, to insolvency