Safe but fragile: Information acquisition, liquidity support and redemption runs

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Abstract

This paper proposes a theory of redemption runs based on strategic information acquisition by fund managers. We argue that liquidity lines provided by third parties can be a source of financial fragility, as they incentivize fund managers to acquire private information about the value of their assets. This strategic information acquisition can lead to inefficient market liquidity dry-ups caused by self-fulfilling fears of adverse selection. By lowering asset prices, information acquisition also reduces the value of funds’ assets-under-management and may spur inefficient redemption runs by investors. Two different regimes can arise: one in which funds’ information acquisition incentives are unaffected by the volume of redemptions, and another where market and funding liquidity risk mutually reinforce each other.

Introduction

The importance of market-based financial intermediaries has grown significantly over the past decades (FSB, 2017, ECB). This includes investment funds such as corporate bond or loan funds offered by asset management companies. While such non-bank financial institutions operate outside the perimeter of traditional bank regulation, they face similar liquidity management problems as commercial banks due to the liquidity mismatch on their balance sheets. Liquidity lines – sometimes referred to as redemption lines of credit – are a frequently used liquidity management tool that allow asset management firms to cover redemptions by borrowing at pre-specified rates from their sponsoring institution or another third party (OFS, 2013). Such outside liquidity support is presumably intended to lower individual firms’ susceptibility to redemption runs by shielding them from deteriorations in market liquidity conditions. However, recent experience of market turmoil and large outflows from funds in the spring of 2020 (Falato, Goldstein, Hortacsu, Jiang, Li, Sun, Wang) suggests that funds can be subject to investor runs, notwithstanding their access to outside liquidity support (Financial Times, 2020).

We argue in this paper that outside liquidity support can, in fact, be a source of financial fragility. In particular, access to liquidity lines incentivizes fund managers to acquire private information about the value of their assets in order to avoid selling good assets at a discount to cover redemptions. We show that this strategic information acquisition can lead to self-fulfilling asset market freezes spurred by endogenous adverse selection which may, in turn, precipitate panic-driven redemption runs.

Our results are based on a three-period model with three types of risk-neutral agents: fund managers, investors, and deep-pocketed secondary market asset buyers. Each manager administers an investment fund that holds a long-term asset on its balance sheet which generates a risky cash flow in the last period. As compensation for managing the fund, managers receive a fraction of the value of their fund’s assets-under-management (AUM). Assets differ in terms of their cash flow at maturity: some yield a high cash flow (good type) while others yield a low cash flow (bad type).

Funds are financed through shares held by investors. A fraction of these shares can be redeemed in the interim period before the asset matures, subjecting funds to a standard liquidity mismatch problem. To cover early redemptions, fund managers can obtain liquidity by either partially selling their asset on a competitive secondary market or tapping an outside liquidity line at an exogenous cost.

Fund managers initially do not know their assets’ type, but they can learn it by incurring a cost in the initial period. The private value of information in our economy stems from fund managers’ option to finance redemptions by tapping their liquidity line rather than selling good assets at a discount.1 By withholding good assets from the secondary market, informed fund managers induce an adverse selection problem that lowers asset prices. This adverse selection effect leads to a feedback from asset prices to managers’ information acquisition incentives as lower prices reduce fund managers’ opportunity cost of tapping their liquidity line in case they have a good asset.

The key contribution of our paper is to show that this feedback can generate self-fulfilling market liquidity dry-ups. To illustrate the underlying mechanism, consider a fund manager who faces early redemptions and believes that other managers have acquired information about their asset’s type (cf. the solid lines of Fig. 1). If informed managers with good assets opt to cover redemptions using their liquidity line, the relative share of bad assets in the secondary market increases and prices fall. This “lemons discount” raises the value of withholding good assets from the market and, a fortiori, the gain from acquiring information. Consequently, the mere belief that others acquire information increases each manager’s private incentive to acquire information, precipitating a self-fulfilling market freeze due to endogenous adverse selection.

This information-induced market liquidity dry-up can also raise investors’ incentives to redeem their shares early. The increased funding liquidity risk arises because funds that sell assets in order to meet early redemptions have to sell increasingly large quantities as prices fall. Early redemptions in this case dilute the claims of investors who hold out until maturity and may lead to self-fulfilling redemption runs if asset prices are sufficiently low (cf. the dashed lines in Fig. 1).

The strategic complementarities characterizing funds’ information acquisition and investors’ redemption decisions can lead to multiple Pareto-ranked equilibria. Equilibria without information acquisition are characterized by high asset prices and low funding risk. These equilibria Pareto-dominate equilibria with information acquisition that are instead characterized by low asset prices and high funding liquidity risk. In order to select a unique equilibrium we employ global game techniques by adapting the methodology of Goldstein (2005).

We show that, depending on the parameters, two different regimes can arise: a classic run regime and an amplification regime. In the former, information acquisition by funds leads to a drop in asset prices that may spur panic-driven redemption runs. However, no reverse feedback exists and market liquidity risk is unaffected by the volume of early redemptions. In the latter regime, market and funding liquidity risk mutually reinforce each other. Funding liquidity risk in this case “spills over” and raises managers’ incentives to acquire information about their assets, amplifying the coordination failure among funds. We show that shocks that raise the cost of liquidity lines can lead the economy to transition from the classic run to the amplification regime.

Our model has implications for both central bank interventions and prudential regulation. Regarding the former, we show that asset purchase programs that place a floor on secondary market prices reduce both market and funding liquidity risk but require the central bank to incur a loss in some states. With respect to prudential regulation, an outright ban on outside liquidity support is desirable in our framework as it prevents asset price declines caused by adverse selection. However, regulations that just raise the marginal cost of liquidity lines (e.g. capital charges on liquidity lines as stipulated by the Basel III Accords) may backfire as they lower the value of funds’ AUM and may thereby amplify funds’ funding risk. Lastly, we show that redemption restrictions including redemption fees and redemption gates can be used to reduce market and funding liquidity risk, but may result in an intertemporal misallocation of consumption across investors.

Related Literature. Our paper is related to several strands of the literature. First, we build on the literature studying how adverse selection frictions can lead to liquidity dry-ups in asset markets, including Akerlof (1970), Plantin (2009) and Malherbe (2014). Contrary to these papers, which treat asymmetric information as a primitive, information frictions in our model are an equilibrium outcome driven by funds’ information acquisition incentives. Our paper also relates to a more recent literature, including Gorton and Ordonez (2014), Fishman and Parker (2015) and Bolton et al. (2016), that focuses on strategic information acquisition in financial markets. Gorton and Ordonez (2014), in particular, argue that agents’ ability to acquire private information about asset values can amplify macroeconomic shocks in collateralized debt markets. Contrary to their framework, financial fragility in our model emerges endogenously due to strategic complementarities in funds’ information acquisition incentives.2

Second, our paper relates to a recent literature studying the consequences of sponsor support on financial fragility, including Parlatore (2016), Ordonez (2018) and Segura (2018). Of these, the most closely related paper is Parlatore (2016) who studies the destabilizing effects of sponsor support in a model with cash-in-the-market pricing frictions. In her model, complementarities arise because fire-sales raise the cost of sponsor support, thereby lowering sponsors’ incentives to provide liquidity and further pushing down asset prices. Our paper focuses on a different channel and shows how the active provision of liquidity support (because of its effect on strategic information acquisition) can be a source of financial fragility.

Third, our paper contributes to the literature studying the feedback between market and funding liquidity. This includes papers by Brunnermeier and Pedersen (2009), Biais et al. (2017) and Kuong (2015) that show how market illiquidity can amplify firm deleveraging due to fire sale externalities. This “margin channel” differs from our “information acquisition channel” in both its empirical and policy implications. Specifically, fire sales result from excessive firm deleveraging caused by binding funding constraints. In our model, prices fall because some firms opt not to sell their assets, which leads to an adverse selection problem in secondary markets. Hence, while the “margin channel” suggests that low asset prices should be associated with high trading volumes our “information acquisition channel” does not. In this sense, our model can rationalize the “double whammy” (Tirole, 2011) of declining prices and trading volumes that characterized many securitized asset markets during the 2007-09 financial crisis.

Finally, our paper draws from the literature on global games that interprets liquidity dry-ups as the result of a coordination failure (Morris, Shin, 2003, Morris, Shin, 2004, Morris, Shin, 2004). Global games serve as the workhorse model for studying bank runs (Goldstein, Pauzner, 2005, Rochet, Vives, 2004), as well as the funding risk of non-bank financial institutions such as hedge funds (Liu and Mello, 2011) and mutual funds (Chen, Goldstein, Jiang, 2010, Morris, Shim, Shin, 2017). Our model studies a novel channel of coordination failure that explicitly ties market and funding liquidity risk to adverse selection caused by strategic information acquisition. Methodologically, our analysis builds on Goldstein (2005) who first extended global games to a setting with two types of agents and a common fundamental.

Section snippets

The model

Agents. We consider a three-period economy t{0,1,2} with a unit mass of investment funds. Each fund j[0,1] is managed by a risk-neutral manager. Fund managers’ compensation is equal to a share β(0,1) of the value of their fund’s assets-under-management (AUM) in t=2. Each fund is financed by a unit mass of risk-neutral investors i[0,1], and each investor holds a single share in a fund. Investors value consumption in t=1 and t=2 and can potentially redeem their shares early. Finally, there is

Exogenous redemptions

This section focuses on the baseline case where an exogenous fraction λ[0,1] of all redeemable shares are withdrawn early. We endogenize investors’ redemption decisions and study the feedback between market and funding illiquidity in Section 4.

Information acquisition and redemption equilibrium

Investor Preferences and Signals. We now turn to the full model with endogenous redemptions. We follow Diamond and Dybvig (1983) and Liu and Mello (2011) and assume that investors are subject to idiosyncratic liquidity shocks in t=1. An investor becomes impatient with probability μ(0,1), implying that a fraction μ of investors always redeem their shares in t=1.12 The remaining fraction 1μ are

Policy implications

Our model has implications for macruprudential measures seeking to limit the fragility of the investment fund sector (ESRB, ECB), including redemption gates and redemption fees. We also discuss the effect of policies seeking to directly boost market and funding liquidity, including government-backed asset purchase programs.

Regulating Liquidity Support. The presence of liquidity lines is the key element incentivizing fund managers to acquire information in our model. Banning the use of such

Conclusion

This paper proposes a theory of redemption runs based on strategic information acquisition by fund managers. The value of information stems from manager’s option to cover redemptions by tapping an outside liquidity line rather than selling good assets at a discount. By withholding good assets, informed managers induce an adverse selection problem in secondary markets that reduces asset prices. Falling prices, in turn, raise investors’ incentives to redeem their shares early and may precipitate

CRediT authorship contribution statement

Philipp J. Koenig: Conceptualization, Methodology, Writing - original draft, Writing - review & editing, Software. David Pothier: Conceptualization, Methodology, Writing - original draft, Writing - review & editing, Software.

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    We thank Joao Santos (the editor), an anonymous referee and Guillaume Plantin for helpful comments and suggestions. We also thank Markus Brunnermeier, Thomas Gehrig, Vincent Glode, Piero Gottardi, Florian Heider, Frank Heinemann, Rajkamal Iyer, David K. Levine, Gyoengyi Loranth, Lukas Menkhoff, Martin Oehmke, Alexander Stomper, Javier Suarez, Harald Uhlig, Todd Walker, Toni Ahnert, Kartik Anand, Christian Basteck, Christoph Bertsch, Ben Craig, Stefan Hirth, Eva Schliephake, Martin Windl, and seminar and conference participants at the Bundesbank, European University Institute, HU Berlin, FTG London Meeting, EEA Lisbon Meeting, GFA Ulm Meeting, VfS Vienna Meeting, Lisbon Meeting in Game Theory and Applications, CEMFI and the OeNB for their helpful comments and suggestions. David Pothier wishes to dedicate this article to the memory of Marina Fasser, and gratefully acknowledges financial support provided by the Deutsche Forschungsgemeinschaft (Grant PO 2119/1). Support from the Deutsche Forschungsgemeinschaft through CRC 649 “Economic Risk” is also gratefully acknowledged. A previous version of this paper was circulated as CRC 649 WP 2016-045 under the title “Information Acquisition and Liquidity Dry-Ups.” Disclaimer: The views expressed in this paper are those of the authors and do not necessarily represent those of the Deutsche Bundesbank or the Eurosystem.

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