Liu, Xuewen, Assistant Professor Imperial College Business School, London
This paper relates the recent financial crisis to the capital structure of modern financial institutions. The theoretical framework of our paper helps to explain some key elements of liquidity crises: 1) the sudden liquidity evaporating in financial markets; 2) the panic and amplifying effects in credit markets; 3) the spiral between low market efficiency and less liquidity. In our model, a shock to market liquidity can lead to leveraged financial institutions to conduct precautionary liquidity hoarding. The shrinking of balance sheets of these institutional lenders causes panic to the spare-liquidity providers and induces them to leave the financial system. The shortage of spare liquidity and thus the lack of arbitrage capital in the system in turn cause a spiral of lower price informativeness and less liquidity.
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