The Paradox of Liquidity

1. FIN 7340 Corporate Theory II Dr. Nina Baranchuk The Paradox of Liquidity Stewart C. Myers Raghuram G. Rajan Presented by: Michael Keefe February 13, 2007

2. External Financing and Liquidity • Tension • Illiquidity => creditors get less if seize and sell assets • Illiquidity => higher probability assets will be there • Greater Liquidity increases conflict over property rights of asset

3. Model Set-Up • The Players • Investor - Principal • Manager/Owner – Agent • Assumptions • Manager has positive $1 NPV project • 2 period model with renegotiation • Cash Flows C1 and C2 are generated at dates 1 and 2 respectively • Project requires purchase and use of asset with replacement cost of d1 and d2 at dates 1 and 2 respectively • $1 NPV => Investment-(C1 + C2 + d2) > 1 • Assume C2 + d2 >= d1 • Index of Liquidity α (i.e. can liquidate for αd) • Information and Contracts • C1 and C2 not observable by Investor • Contractual Variables • Ownership of Asset => right to choose who operates or sell asset • Cash Paid by Manager to Investor can be verified and contracted on • Manager can not operate asset efficiently

4. Liquidity and Transformation Risk • Investor Worries • Manager Steals Asset (e.g. commodities) • Sell asset and take cash (payoff proportional to liquidity) • Transform to assets specific to manager expertise • Substitute with risky assets (shift value from debt to equity) • Nature of Liquidity • Initial Assumption αm=α • Efficient legal system => αm<α • Trader => high transformation risk due to opaque environment (complex positions not easily monitored)

5. The Order of Play

6. Date 2 Negotiation (Manager, Investor) (C2+d2-X, X) Accept Inv Mngr Offer X (C2+d2-P2,P2) Reject Pay Mngr Not Pay (C2, αd2) Result – Manager offers min[P2,αd2] Note – Manager and Investor both KNOW α, d2, and P2

7. Date 1&1/2 Incentives (Manager, Investor) (αd2,0) Transform Mngr Continue (C2+d2-min[αd2,P2], min[αd2,P2]) It is in the incentive of investor to insure the Manager continues.

8. Date 1 Negotiation Nature acts w.p. a investor makes offer & w.p. (1-a) manager makes offer Yes Take Inv 1. Mngr a Leave No Inv Reject Nature Mngr Offer X (1-a) Yes Mngr 1. Inv Take Leave No 1. Given bargaining power investor or manager will each make take it or leave it offer (Demand C2) Since investor can force liquidation at Date 1, the value to Lender is:

9. Date ½ Incentives • Manager can transform asset and receive αd1 • The Manager can commit to not transform assets only if: • The Investor will only offer financing at date 0 if:

10. Maximum Debt the Manager can commit to repay

11. Scenario I – Large C2 and P1 • (9) & (10) do not bind • (8) reduces to: • Note that d1 is greater than d2

12. Date ½ Transformation Risk Constraint (7)

13. Financing Capacity Example

14. Financing Capacity • Assumption – Assets of a firm can not be transformed or liquidated seperately • Constraints bind over three possible ranges of liquidity • (a) Illiquid – Debt determined by cash flows and final liquidation • (b) Liquid – Debt determined by liquidation value of assets • (c) Overly Liquid – Debt capacity reduced by excessive liquidity • Ranges

16. Robustness • Equity – Manager can beat investor to transformation • Investor has unconditional ownership and not conditional on default • Investor pays salary (assume large enough to cause default and start negotiation process) • If (7) binds manager will tranform • Transformation incentive of manager reduced when illiquid projects added (way to check transformation risk) • Endogeneity – Manager gives up transformation ability to get more internal financing

17. Manager Flexibility – Set Up

18. Endogeneity Findings • If f is concave in b, the b* is • increases with cash flow • decreases with θ • decreases with the date 1 value of assets (less opportunity for transformation with small d1) • Relationship between optimal flexibility and liquidity depends on fb,α • fb,α small then db*/dα negative (buy and hold assets) • fb,α large then db*/dα decreases (e.g. trader requires more flexibility)

19. Transformation Risk Entrenching Investment – Manager can substitute general purpose assets into specific assets - Shleifer and Vishny (1989) Results also hold when specific assets can be transformed

20. Banking • Banks originated in middle ages as money changers due to quality issues with coins. (DeRoover 1948) • Kept 30% of deposits as reserves • Laws focussed on preventing fraud Riu(1979) • Governments formed banks • Transformation risk endured (war, fiscal distress) • 100% reserves and still defaults • Why did the government banks not put the private banks out of business? • Municipal kept 100% in liquid asset reserves => temptation for municipality to raid • Illiliquid loans and investments of money changer served to bind the liquid assets of the money changer

21. Banks Today • Assets – Mix of illiquid loans and liquid securities • Liabilities – Short Term Deposits • Model to Banking • For banks to serve demand depositors => need liquidity; however scale will not solve transformation issue • Banks make illiquid loans to increase debt capacity

22. Bank Model Set-Up • Approach & Findings • Evaluates recourse of individual investors if bank misses payment • Individual investor gets reduced payoff • Implication is that intermediation may not dominate direct lending

23. Contrasting Theories • Diamond and Dybvig (1993) – Banks exist to so consumer can fund uneven consumption and fund projects • Calamiris and Kahn (1991) – First come first serve nature of banks incent depositors to monitor • Transformation risk of banks is increasing due to technology=>hard for banks to make loans to most credit worthy accounts • M&M world – A credit rated bank could make loan to AAA company and get correct return • Model – Transformation risk does not allow loan to fall to cost of capital of that loan.

24. Conclusions • Transformation Risk => Debt Capacity is not monotonic in the intrinsic liquidity of assets • Assets in an overly-liquid firm can not be used as collateral for debt => debt capacity is increased by taking on less liquid projects