Liquidity Needs in Economies with Interconnected Financial Obligations

A model is developed where firms in a financial system have to settle their debts to each other by using a liquid asset (or money). The question that is studied is how many firms must have access to this asset from outside the financial system to make sure that all debts within the system are settled. The main result is that these liquidity needs are larger when these firms are more interconnected through their debts, i.e., when they borrow from and lend to more firms. Two pecuniary externalities are discussed. One is the result of paying one creditor first rather than another. The second occurs when firms increase their financial transactions and thereby make it more likely that others will default. Lastly, the paper shows that interconnections can raise the number of firms that must be endowed with liquidity even when payments paths are chosen by a planner that seeks to avoid defaults. (JEL G20, D53, D85) ∗Harvard Business School, Soldiers Field, Boston, MA 02163, [email protected]. I wish to thank seminar participants at the University of Houston, Brandeis University, MIT and the Federal Reserve Bank of Atlanta as well as Stephen Cecchetti, Pablo Kurlat, Ivan Werning and Michael Woodford for comments. The last few years have seen an explosion of two types of financial transactions. First, the volume of derivative instruments that are purchased and sold has ballooned. To give just one example, the face value of “credit derivative swaps” may have reached $60 trillion by May 2008. Many of these derivative contracts require one side or another to make payments at pre-specified points in time. These required payments fluctuate in value and, to hedge against the resulting risks, many participants in these markets engage in simultaneous transactions with several parties so that their net payments are typically small. The second, and related, change is that a vast number of new intermediaries have been created whose main activity consists in engaging in financial market transactions. In addition to being active in derivatives markets these intermediaries borrow from other financial firms while simultaneously acquiring claims on others. This raises the obvious question of whether this interconnectedness strengthens or weakens the financial system as a whole. Within this broad question, the current paper focuses on a narrow one. It focuses on a situation where every firm is solvent in the sense that the payments that any particular firm is expected to make do not exceed the payments it is entitled to receive. It then asks whether interconnectedness exacerbates the difficulties that firms have in meeting their obligations in periods where liquidity is more difficult to obtain. In practice, firms make their payments with money, and legal tender laws ensure that this medium is always acceptable. A difference between financial firms and other economic actors is that, at least in “normal” times, these firms are continuously involved in markets such as the repo market where assets are exchanged for money within the day. Outside of liquidity crises, the range of assets that can be used for this purpose is relatively large. Solvent firms thus have no difficulty making their required payments. The cost involved in temporarily borrowing funds to make payments and returning these funds as soon as payments are received is small enough that it can be neglected relative to the difficulties encountered in liquidity crises. In such crises, short term funding becomes more difficult, as manifest for example in the reductions in the volume of “repo” transactions after the collapse See Reguly (2008) who also discusses the relationship of this volume to hedge funds.