Endogenously Declining Liquidity and Rollover-Risk Spillovers

This paper studies a short-term debt market in which rollover risks spread across heterogeneous banks because a liquidation price of assets declines over time endogenously. To this aim, the paper uses a general equilibrium approach to analyze interactions between the primary and secondary debt markets. Specifically, in this economy, rollover decisions of creditors and takeover-timing decisions of potential buyers of assets determine the supply and demand for failed assets, respectively. A liquidation price clears the market in equilibrium. In fact, the paper assumes potential buyers have different asset-management abilities and highly skilled buyers are scarce. Thus, a less and less skilled buyer becomes a marginal buyer as time goes by, pushing down the liquidation price. This liquidation-driven pecuniary externality is what propagates rollover risks across different banks. The model further implies injecting emergency funds to only a tiny number of banks may trigger earlier runs on those banks. Extending debt maturities causes a similar consequence. The paper develops a new method to characterize transition dynamics of equilibrium analytically.