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Debt Runs and the Value of Liquidity Reserves

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  • Fabrice Tourre

    (University of Chicago)

Abstract

This article analyzes a firm prone to debt runs, and the effect of its portfolio liquidity composition on the run behavior of its creditors. The firm holds cash and an illiquid asset, and is financed with term debt held by a continuum of creditors who decide whether to extend new financing when their debt claim mature. When the firm’s portfolio value deteriorates, creditors are inclined to run, but their propensity to run decreases with the amount of available liquidity resources. The theory has policy implications for micro-prudential bank liquidity regulation: for any leverage ratio, it characterizes the quantity of liquidity reserves a firm should hold in order to deter a run. I solve the model numerically and perform comparative statics, varying the firm’s illiquid asset characteristics and the firm’s debt maturity profile. I discuss the influence of the firm’s portfolio choice and dividend policy on the run behavior of creditors. Two key results emerge: current bank liquidity regulations are too punitive for highly capitalized banks and not conservative enough for less well capitalized institutions, while longer term liabilities do not always lead to less run-prone banks.

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  • Fabrice Tourre, 2016. "Debt Runs and the Value of Liquidity Reserves," 2016 Meeting Papers 709, Society for Economic Dynamics.
    • Handle: RePEc:red:sed016:709
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    References listed on IDEAS

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