Moral Hazard, Collateral and Liquidity

We consider a moral hazard setup wherein leveraged firms have incentives to take on excessive risks and are thus rationed when they attempt to borrow in order to meet liquidity shocks. The rationed firms can optimally pledge cash as collateral to borrow more, but in the process must liquidate some of their assets. Liquidated assets are purchased by non-rationed firms but their borrowing capacity is also limited by the moral hazard. The market-clearing price exhibits cash-in-the-market pricing and depends on the entire distribution of liquidity shocks in the economy. As moral hazard intensity varies, equilibrium price and level of collateral requirements are negatively related. However, compared to models where collateral requirements are exogenously specified, the endogenously designed collateral in our model has a stabilizing role on prices: For any given intensity of moral hazard problem, asset sales are smaller in quantity, and, in turn, equilibrium price is higher, when collateral requirements are optimally designed. This price-stabilizing role implies that the ex-ante debt capacity of firms is higher with collateral and thereby ex-post liability shocks are smaller. This stabilizes prices further, resulting in an important feedback: Collateral reduces the proportion of ex-ante rationed firms and thus leads to greater market participation. Our model provides an agency-theoretic explanation for some features of financial crises such as the linkage between market and funding liquidity and deep discounts observed in prices during crises that follow good times.credit rationing; financial crises; fire sales; funding liquidity; market liquidity; risk-shifting