Political Connections And Business Strategy

This paper presents a model that considers 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-inthe-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. This 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.