2601167 (2)

Liquidity and Risk Management
Author(s): Bengt Holmstrm and Jean Tirole

Source: Journal of Money, Credit and Banking, Vol. 32, No. 3, Part 1 (Aug., 2000), pp. 295-319
Published by: Ohio State University Press
Stable URL: http://www.jstor.org/stable/2601167
Accessed: 20-03-2015 12:33 UTC
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MONEY, CREDIT, AND

BANKING T,E,CTURE
LiquidityandRiskManagement
BENGT HOLMSTROM
JEAN TIROLE
Firms and financialinstitutionsarebest viewed as ongoing entities,
whose project completion may requirerenewed injections of liquidity. This paper proposes a contract-theoreticframeworkintegrating three dimensions of corporate financing and prudential
regulation:(1) liquiditymanagement,(b) risk management,and (c)
capital structure.It concludes with a preliminaryassessmentof recent regulatoryapproachesto the treatmentof marketrisk.
THIS PAPERIS CONCERNED
with the corporatedemandfor
liquidity and the various ways in which firms in the real and the financial sectors
managetheir liquidityneeds so as to be able to carryout productionand investment
plans effectively withoutbeing held back by temporaryliquidity shortages.Several
key decisions impact a corporation'sfutureability to avail itself of financialfunds.
First, the corporation'scapitalstructuresets, among other things, a timetablefor
reimbursinginvestors.Short-termdebt forces the firmto pay out cash, dryingup liquidity. Long-term debt allows the Elrmmore room to adjust to liquidity shocks,
exertingpressuremainly by the constraintsit places on the amountof new debt that
can be raised. Preferredstock explicitly embodies a liquidity option (a form of line
of credit)by allowing the firmto delay reimbursement.Equityis, of course, the most
accommodatingclaim with no precise timetablefor the paymentof dividends.
Second, corporationsdo not invest all theirresourcesin profitable,long-termprojects. They also invest in less profitableliquidassetsthat are held on their balance
sheets as buffers against shocks. We define a liquid asset as one that the firm can
quickly resell or pledge as collateralat its true value andwhose marketvalue is unlikely to be depressedwhen the firmneeds resources.Looking at this dual condition,
Thislecturewasdelivered
April16, 1999,at OhioStateUniversityby thesecondauthor.Theauthors
aregratefulto theparticipants
forhelpfulcomments.
BENGTHOLMSTROM
is Paul A. Samuelson Professor of Economics at MIT. E-mail:
bengt@mit.edu.JEANTIROLE
is professor of economics at IDEI and GREMAQ,Toulouse,
CERAS,Paris, and atMIT. E-mail: tirole@cict.fr
Journalof Money,Credit,and Banking,Vol. 32, No. 3 (August 2000, Part 1)
Copyright2000 by The Ohio State University
296
: MONEY,CREDIT,AND BANKING
we observe that the first partis just the notion of liquidity emphasizedin the literature on marketmicrostructure.The second partis the analog of the covariancecondition in the consumptionCAPM model stemming from the producers'demandfor
liquidity [see Holmstrom-Tirole(1998a) for the derivationof liquiditypremiain this
context and a discussion of how they differ fromrisk premiain a consumption-based
asset pricing model]. The firm's demandfor a liquid asset depends on whetherand
how much the asset will deliver when the firm needs cash. In this respect, corporate
equity or commercialreal estate may be poor instrumentsfor securingliquidityeven
when they are liquid in the sense of marketmicrostructuretheory. Short-termtreasury bonds bettersatisfy our two conditions as do cash instruments,of course.
Ratherthanhoardingliquiditythemselves, corporationsmay secure lines of credit
from finaricialinstitutions.lFor example, they can contractwith a bank or an insurance companyfor the right to draw a specified amountof cash at a given rate of interest by a given date in exchange for an upfrontcommitmentfee. The associated
liability for the financialinstitutionmustbe backedup by an increasein its liquid assets, sufficientto make it likely thatit can deliveron its promise.Liquidityprovision
is an importantactivity of banks. For example, roughly 80 percent of commercial
and industrialloans at large U.S. banks are take-downs under loan commitments
(Greenbaumand Takor1995).
Third,corporationsengage in riskmanagement.
They can use derivativesto hedge
specific risks (interestrate,currency,raw materials,etc.). For example, a corporation
with substantialexportsmay quickly become shortof cash if the exchange rate suddenly turns unfavorable.Foreign exchange swaps allow the firm to insure against
this type of liquidity shortage.Using derivativesand forwardand futuresmarketsis
only one of many ways in which firms can cover themselves against specific risks:
other ways include securitization,insuranceagainst theft, fire or the death of a key
employee, trade credit insurance and diversificationof various sorts (geographic,
productmix, etc.).
Last, corporationsalso attemptto measure their global risk exposure. Sophisticated tools, such as RAROCor Risk Metrics,give an imperfect,but useful pictureof
a firm's or bank's exposure to various macroeconomicfactors. Such Value at Risk
(VAR) models, extensively used by banks to control their dealers' and traders'risk
taking,andby prudentialregulatorsto monitorbanks,estimatethe extremelower tail
risk of a portfolio. The value at risk is the level of loss that will be exceeded with
some prespecifiedprobability(1 percent, 5 percent, ...) over some time horizon (1
day, 10 days, a year, ....)2 The purposeof such models is to assess the probabilitythat
an entity runs into a serious liquidityproblemand is forced into a costly liquidation
of assets. These models have become popularin the 90s in the wake of recent scandals at Barings,Procter& Gamble,Metallgesellschaft,and the OrangeCounty.
1. For more on lines of credit and loan commitments,see Crane(1973) and Greenbaumand Thakor
(1995).
2. See Duffie and Pan (1997) and Gordy (1998) for a review of the techniques employed in such
models.
BENGT HOLMSTROMAND JEAN TIROLE : 297
The Arrow-Debreumodel, the cornerstoneof modernfinance,offers few clues for

understandingthe above-mentionedthreepractices,let alone how they arerelated.In
the Arrow-Debreumodel capital structureis irrelevant(Modigliani-Miller).Nor do
firmsneed to hoardliquid assets, since they can issue claims againstthe full value of
the new investments(see below). Finally, claimholderscannot gain by having firms
engage in risk management,since reshufflingstate-contingentresources in a complete marketdoes not affect the marketportfolio.
Two argumentsthat have been put forwardto explain the value of liquidity management are taxes and managerialincentives. Taxes are specific to locality and time
and do not appearvery helpful in explainingthe observedpatternsof liquiditymanagement (Stultz 1996). And while risk managementtechniquescould be used to filter out some of the exogenous noise in managerialcompensation (Fite-Pfleiderer
1995; Stulz 1984, 1996), Froot, Scharfstein,and Stein (1993) rightly observe that
this argumentdoes not make a strong case for risk management,since the same
could be accomplishedby building the filter directly into the manager'scontract.It
has also been suggested that corporaterisk managementreduces the risk of bankruptcy,but withoutan explanationof why bankruptcyleads to inefficientliquidation
andreallocationof assets,3this point is subsumedin the earlierobservationthatissuing new claims in a complete marketwill not improvethe claimholders'lot.
In our analysis, liquiditymanagementderives its rationalefrom the corporations'
concernfor refinancing,a concernemphasizedin variouscontexts by Thakor,Hong,
andGreenbaum(1981) andFroot,Scharfstein,and Stein (1993) among others.In the
Arrow-Debreuworld, refinancingis not a concern because the entire benefit from
reinvestmentcan be pledged to outsideinvestors.Consequently,any positive net present value project can be funded at the time the opportunityfor investmentarises.
Even when there is a debt-overhangproblem, the initial debtholderscan be persuadedto exchange their claims for more valuableones in orderto raise the needed
capital.The situationis very differentwhen claims on the full value of the firmcannot be issued. If part of the corporatecake is nonpledgable,because insiders (managers, workers,owner-monitors,etc.) have to hold a share of that cake in order to
behave properly,or if insiders enjoy significantprivatebenefits for some other reason, it is possible that an (ex ante) socially beneficial liquidity need cannot be met
unless the firm has secured sufficientliquidity in advance (see, for instance, Holmstrom and Tirole 1998b). Long-termfinancingis also of value if assets can become
temporarilyilliquid (nonpledgable)because of adverse selection problems (see, for
instance, von Thadden 1995). Informationabout the true value of a firm's assets is
typically limited to a smaller set of experts. If these expertshave difficultiesraising
funds at the same time that the firm needs liquidity,the firm's assets cannot be sold
at full value. While adverseselection may be a realisticreason for illiquidity,we will
rely on our own moral hazardmodel to study the three earlier-mentionedaspects of
liquiditymanagementbecause of its greaterease of use.
3. See, however, Caillaud,Dionne, and Jullien (2000) for a model of hedging in the presence of endogenous bankruptcycosts.
298
The paperis organizedas follows: Section 1 models corporateliquiditydemandas

in HolmstromandTirole (1998b) and applies the frameworkto the analysis of financial structure.Sections 2 through4 contain the more novel material.Section 2 applies this model to the free cash flow problem and undesiredrefinancing.Section 3
derivesthe optimalrisk managementstrategy.Last, section 4 providesa preliminary
analysis of the regulatorytreatmentof marketrisk in prudentialregulation.In 1996
the Basle Committee amendedthe 1988 internationalaccord on prudentialregulation to incorporatemarketrisk, in reaction to the concern that banks' tradingbook
losses might jeopardize their ability to manage their banking book. Section 4 assesses recentregulatoryapproachesto marketrisk in the light of section 3.
While this paper focuses on microeconomic issues, liquidity considerationsare
centralto a numberof other topics such as asset pricing and country-wideliquidity
crises, which will not be pursuedhere (see Caballeroand Krishnamurthy1999).
1. MODELINGCORPORATELIQUIDITYDEMAND
1.1 Roadmap
In orderto study corporatedemandfor liquidity we need to extend the standard
two-periodmodel of investmentto include an intermediate,thirdstage at which the
firmmight need additionalfunding(see Figure 1 for a representationof the timing of
the model). Initially,we assume thatthe firmdoes not produceany income at the intermediatestage; rather,it may be hit by an adverse shock and requiredto plow in
some extracash in orderto be able to continuethe project.Thereare two approaches
'tCashpoorfirtrl'l
Cashneed
/
/ overruns
/reinvestment
\shortfallin earnings
Continue
Financing
Outcome
Liquidation
downsuing
FIG.
BENGT HOLMSTROMANDJEAN TIROLE : 299
the firm can take to deal with urgent liquidity needs. The first is to secure some
source of liquiditybefore the shock occurs. For example, the firm may keep liquid
assets such as treasurybills on its balance sheet or it can secure a line of creditfrom
a bank.In the second approachthe firm waits for the shock to occur before its starts
raisingfunds.
We will show that the wait-and-see approach does not sufElcewhen liquidity
shocks are exogenous. There will be situationswhere the firm would have been rescued underan optimalex ante contract,but will fail withoutsuch a contract.Neither
initial lendersnornew lenderswantto rescue the firmin certainstatesunless the firm
securedliquidity services in advance.This is due to the fact that the borrowermust
always keep a stake in the firm and hence the firm's full value cannot be pledged to
the outsiders.Consequently,the lenders do not internalizethe loss incurredby the
borrowerwhen the projectis stopped,resultingin excessive liquidation.
1.2 OptimalLiquidityManagement
At date Oan entrepreneur(also called the "insider"or the "borrower")can invest
in a projectwith constantreturnsto scale. The scale of the project,I, is a continuous
variablethatcan be selected freely.
The entrepreneurinitially has "assets"or "net worth"A. These assets could be
cash or liquid securitiesthat can be used to cover the cost of investment.To implement a projectof scale I > A the entrepreneurmust borrowI-A.
A projectstartedat date Oand continuedat date 1 (see below) either succeeds, that
is, yields verifiableincome RI > Oat date 2, or fails, thatis, yields no income at date
2. The probabilityof success is denotedby p. The projectis subjectto moralhazard
between dates 1 and 2. The entrepreneurcan "behave"("work,""exerteffort"), or
"misbehave"("shirk");or, equivalently,the entrepreneurchooses between a project
with a high probability of success and another project which ceteris paribus he
prefers(is easier to implement,is more fun, has greaterspin-offs in the futurefor the
entrepreneur,benefitsa friend,etc.), but has a lower probabilityof success. Behaving
yields probabilityP = PH Of success and no privatebenefit to the entrepreneur,and
misbehavingresultsin probabilityP = PL < PH of success and privatebenefitBI > O
(measuredin units of account)to the entrepreneur.Let Ap--PH - PL. In the "effort
BI can also be interpretedas a disutility of effort saved by the entreinterpretation,"
Note that the privatebenefit is proportionalto investment.
shirking.
preneurwhen
the rate of interestis taken to be zero. Both the borrower
simplicity
For notational
(or
and the potentiallenders "investors")are risk neutral.The borroweris protected
by limited liability.Lendersbehave competitivelyso that loans make zero profit.
After investmentI is sunk at date Obut before the entrepreneurworks on the project, an exogenous liquidityshock p E [O,) occurs at date 1. A cash infusion equal
to pI is neededto cover "cost overruns"and allow the projectto continue.If pI is not
invested,the projectis abandonedand thus yields no income. The fraction p is distributedaccordingto the continuousdistributionF(p) on [O,oo),with densityt(p).
Regardlessof the requiredfractionof the cash infusion, the project,if pursued,is
still a projectof size I, in that the income in case of success is RI and the borrower's
300
privatebenefit from misbehavingis BI. One cannot increase the size of the project
afterthe initial stage. The timing is summarizedin Figure 2.
We assume that the investmenthas a positive net present value. That is, under a
rule that specifies thatthe projectis abandonedif and only if p ' p for some threshold p, the expected payoff per unit of investment is strictly positive. The positive
NPV conditionunderliquidity shocks is
m-ax{F(p)pHR-1-Jo pf(p)dp} > 0 *
(1)
We firstlook for the optimal loan agreementand later discuss its implementation.
It is easy to show thatit is optimalto have a "cutoffrule"for the date-l reinvestment.
Thereexists a thresholdp* such thatit is optimalto continueif and only if
P ' P*
(2)
The incentive constraintin case of continuationrequiresthat the borrower'sstake in

case of success, Rb, times the reductionin the probabilityof success due to shirking
be largerthan the privatebenefit from shirking (due to risk neutralitythe entrepreneuroptimallyreceives 0 in case of failure):
(P)Rb ' BI.
(ICb)
The break-evenconditionfor the investorsis

F(p*)[pH(RI-Rb)]-I-A
+ IP pIt(p)dp
(IRe)
The lendersreceive a returnonly if the projectis continued,which occurs with probability F(p*). The left-hand side of (IR) is the expected pledgeable income. The
right-handside is the investors' date-0 outlay, I-A, plus the expected liquidity
need. From these two constraints,we deduce the "debtcapacity"(or more precisely
the maximalinvestmentthat allows the lendersto breakeven):
Date 0
)<
Loan
agreement
Date 1
)<
Investment
I
3<
Need for
cash infusion
pI realized
Disbursement
Date 2
)<
Moral
hazard
No disbursement
Project is abandoned
FIG.2
)( b
Outcome
I = k(p*)A,
where
1 + JP p+(p)dp-F(P*)[PHR-PH
API
1
1
(3)
+JPp+(p)dp-F(p*)po
Note that the borrower'sdebt capacity is maximal when the thresholdp* is equal to
the unit expected pledgeableincome Po-PH
/
B \
VR--J
.
Given that lenders make no profitsthe borrower'snet utility is the social surplusof
the project,namely,
Ub = m(p *)I = m(p *)k(p *)A
where
m(p*)--F(p*)pHR-1-JP
p+(p)dp
(4)
is the marginper unit of investment.

Whatis the optimalcontinuationrule?Intuitionmight firstsuggest that,given that
liquidity shocks are exogenous, one would want to continue if and only if this is ex
post efficient, thatis, if and only if p ' pHR.Indeed,p* = pHR= P1,maximizes the
marginm(p*). However,at p* = pHR,the multiplierk is decreasingin p*. So one actually ought to choose a lower thresholdthan the ex post efficient one. It is easily
seen from (3) and (4) that
1+JP*
pf(p)dp
ub=
F(p*)
A,
1+JP pf(p)dp
B\
F(p*)
AP J
and so the optimal thresholdminimizes the expected unit cost c(p*) of effective investment:
302
p * minimizes c(p*) = 1+ lo Pf(p)dp

or
JoP
F(p)dp = 1.
(6)
Condition(6) can be obtainedby integratingby partsandrewritingthe expected unit

cost, of effective investmentas
1-JP*
F(p)dp
This expression also shows that at the optimum,4the threshold liquidity shock is
equal to the expectedunit cost of egffectiveinvestment:
c(p*)=
p*.
This in turnimplies thatthe borrower'snet utility is

P1 -p*
Ub=p*_p
A.
(7)
Next, we observe that this optimal thresholdlies between the pledgeable income
poand the expectedreturnP1

(
/\P )
(8)
This follows from the fact that the marginm(p*) and the multiplierk(p*) are both
decreasing above P1 and both increasingbelow pO:see Figure 3.5 Condition (8) is
consistent with (7): If p* were to exceed P1,the projectcould not be financedprofitably.If p* were lower thanpO,the debt capacityandthe borrower'sutility would be
infinite.6
4. It is easy to show that c(-) is quasi-convex(c"(p*) > Oif c'(p*) = O).

5. Indeed, m(-) is quasi-concavewith a maximumat Pl and k(-) is quasi-concavewith a maximumat
Po
6. Note that p* does not dependon pOand Pl as long as it falls between the two. The investmentscale
only dependson pO.
investment multiplier
>(P)
p*
Po
pledgeable
income:
maximizes
debt capacity
P1
NPV:
maxirnizes
profit
per uIiit of
investment
P
liquidity
shock
FIG. 3
We conclude that the pervasive logic of credit rationing applies not only to the
choice of initial investment,but also to the continuationdecision. In orderto be able
to investmore ex ante,the borroweraccepts a level of reinvestmentbelow the ex post
efficientlevel (p* < pHR).The logic is important.Because the entrepreneuris credit
constrained,his returnon internalfunds (A) exceeds the marketrate (O).Therefore,
he does not want to buy full insuranceagainstthe liquidityshock p (thatis, set p* =
P1)At full insurancethe marginalreturnfor his money is zero, while the marginalreturnfrom expandingscale is strictlypositive.
Equation(8) implies that a wait-and-seepolicy, underwhich the borrowertries to
raise funds from the lenders afterobservingthe liquidity shock, is suboptimal.Even
underperfect coordination(there is no "debt-overhang"phenomenon),lenders will
provide new credit at date 1 only if the pledgeable income exceeds the amount of
reinvestment,thatis, only if p < pO.Because pO< p*, it is optimalfor the borrower
to secure in advance more funds than can be raised by a wait-and-seepolicy. This
createsa corporatedemandfor liquidity.See Figure4 for a summaryof our findings.
Condition (6) has an interestingimplication.An increase in the riskiness of the
liquidity shock in the sense of a mean-preservingspreadof F7 raises the left-hand
side of (6) and thus reduces the thresholdp*. So, the borrowershould hoard more
liquiditywhen the liquidityshock incursa mean-preservingreductionin risk, as may
occur,for example, when a new marketopens that allows the firmto insure againsta
7. See, for example, Rothschild and Stiglitz (1970, 1971). The distributionG(p) (with density g(p),
say) is a mean-preservingspreadof distributionF(p) if
lUDO
lUDO
lUDO
lUDO
(i) Jo G(p)dp = Jo F(p)dp ( Jo pg(p)dp = jo p0(p)dp,so the means are the same), and
rP
rP
(ii) J0 G(p)dp 2 J0 F(p)dp for all p.
304
capital
marketwilldo
l
'
inefficient
liquidadon
underwait-and-see
policy
Po
I '
positirre
net pledgeable
income
continuation
P1
I
v
,p
'
positiveNPV,
negative
netpledgeable
mcome
continuation
negative
NPV
continuation
FIG. 4
previously uninsurablerisk. Furthermore,(7) shows that welfare increases with an

increase in the riskiness of p. The reason is the option value of discontinuingthe
project.Ex ante uncertaintyaboutthe liquidity shock p is a key ingredientin the demand for liquidity.Suppose p were deterministic.If p
2 po = pH(R
B ), then
investorsdo not want to lend at date 0, since they know that they will have to cover
at date 1 a liquidity shock that exceeds the income that can be pledged to them at
date 2. Therewill neverbe anythingto distributeto investors.If p < pO,then the firm
is always solvent at date 1, and new claims can be issued at date 1 (thatpartiallydilute existing ones) in orderto meet the liquidity shock and continue;hence there is
no need to hoardreserves.
A good way of thinkingaboutthis issue is in terms of insurance.A high liquidity
shock is similarto an illness or an accident,and a low liquidityshock is similarto an
absence of such a mishap.There is no scope for insuranceif it is known in advance
whetherthere will be an illness or an accident.
1.3 Implications
The firstimplicationof our analysishas alreadybeen stated:because the firmmay

not be able to raise funds to pursuecertainworthwhileprojectsat date 1, it ought to
make sure at date Othat it can avail itself of some liquidity.If negotiationsrun frictionessly at date 1, the firmcan raise up to the pledgeableincome (poI) in the capital
marketat thatdate. Thus the minimumamountof liquiditythatthe firmmust secure
at date Ois the differencebetween the targetedreinvestmentand the pledgeable income, thatis, (p*-po)I.
At, this stage, the theory says nothing aboutthe natureof this liquiditybuffer.The
firm can hold liquid securities on a balance sheet, or contractwith an intermediary
for a creditline. It is only when liquidityis scarce at the economy level andliquid as-
sets thereforesell at a premiumthat economic agents must organizethe dispatching

of liquidity so as not to waste it. Wasteoccurs when in some state of natureat date 1
assets are held by an economic agent who does not need them while anotheragent is
short of liquidity. The transfer of liquidity between these two agents cannot be
arrangedat date 1 because the latter agent is unable to pledge enough to make it
worthwhilefor the formeragentto lend. We referthe readerto HolmstromandTirole
(1998b) for a discussion of wasted liquidity and the role of intermediariesas liquidity pools.
For the moment the theory also says nothing aboutthe maturityof claims on the
firm. Since the firm does not produce any cash flow at date 1, all reimbursements/
dividendsmust be paid at date 2. We now relax this assumptionby allowing the firm
to generatea profitat the intermediatestage.
2. INTERMEDIATEINCOME,FREE CASH FLOW,AND THE SOFT BUDGET CONSTRAINT
Let us first extend the model by assuming that the firm generates an exogenous
(for simplicity),deterministic,and verifiablecash flow, rI, at date 1, where r ' 0: see
Figure 5.
To solve for the optimalfinancingcontract,we do not need to redo the analysis of
section 1.2. Intuitively,since the pledgeableincome as well as the NPV are increased
by the amountrI, the unit cost of investmentis no longer 1, but 1-r. The formulae
above remainunchangedexcept thatthe cutoff p* is determinedby
(9)
tP F(p)dp = 1-r .
Even thoughthe results closely trackthose of the liquidity shortagemodel of section 1, it is importantto note that the short-termincome, while deterministicand
Loan
agreement
Investment .
Date 1
.
*.
Date 0
x
Date 2
Disbursement
X
)<
)(
Moral
hazard
* Accrual of
short-term
income rI
No disbursement
* RealizationpI
of investmentneed
..
Project is abandoned
FIG.
)<
>
Date-2
income
(RI or 0)
306
fully pledgeable, is not equivalentto an increasein the borrower'sequityA. Such an

increase in equity would result in a largerinvestment(as is the case here), but not in
a modification of the continuationrule. By contrast, condition (9) shows that the
largerthe short-termprofit, the lower the optimal thresholdp*. To understandthis
point, recall the scale expansion-insurancetrade-offbetween increasingdebt capacity (by reducing p*) and increasing the probabilityof continuation(by increasing
p*). The short-termrevenuemakes investmentmore attractiveandthereforemakes it
worth sacrificingcontinuationmore in orderto boost debt capacity.
While young firmsor firmswith substantialinvestmentneeds are well depictedby
the liquidity-shortagemodel of section 1, Easterbrook(1984) and Jensen (1986,
1989) consideredthe opposite situationof "cash-richfirms"that generatelarge cash
inflows exceeding theirefficientreinvestmentsneeds. Such firmshave excess liquidity that must be "pumpedout" in order not to be wasted on poor projects, unwarranteddiversification,perks,and so forth.Jensen's(1989) list of industrieswith huge
free-cash-flow problems in the 1980s includes oil, steel, chemical, television and
radiobroadcasting,brewing,tobacco, and wood and paperproducts.
The liquidity-shortageand free-cash-flowproblemsare opposite sides of the same
coin. The key challenge in liquidity managementis to ensure that, at intermediate
dates,just the right amountof money is availablefor paymentof operatingexpenses
and reinvestments.Whetherthis results in a net inflow (the liquidity-shortagecase)
or outflow (the free-cash-flowcase) is importantfor corporatefinance, but from an
economic point of view there is no conceptual distinction. Indeed we can merely
reinterpretthe liquidity-shortagemodel as a free-cash-flowmodel without changing
the analysis.8
More formally, let us make the following free-cash-flow assumption: r > p*.
Under the free-cash-flowassumption,and given that the entrepreneurcannot steal
the intermediateincome, the entrepreneurwould reinvestexcessively. He would continue as long as p ' r.
To obtainthe optimalreinvestmentrule, an amount
P1-(r-p*)I,
must be pumpedout of the firm.
The payment P1 can be interpretedeither as repaymentof short-termdebt as in
Jensen or as a dividendpayment as in Easterbrook.Note, though, that the dividend
must be cappedby a covenant.Otherwise,investorswould want to pay dividendsup
to (r-po)I > P1 in orderto preventthe entrepreneurfrom reinvestingwheneverthe
liquidityshock exceeds the date-1 pledgeableincome p0.Withthis interpretation,we
see that covenants specifying a maximumof dividendpayment serve to protect the
entrepreneuragainstexcessive liquidation.9
8. For a relatedstudy of free cash flow and liquidity,see Krishnamurthy(1998).
9. This insight complements the standard and important explanation for the existence of such
covenants. They are usually viewed as protectingcreditorsagainst expropriationby the equityholders,
who could use dividenddistributionsand sharerepurchasesto leave creditorswith an "emptyshell."
Until now, we have assumed that the date-l income is exogenously determined.
Let us briefly consider the case in which income is influencedby the entrepreneur's
date-Oeffort eO.It is naturalto assumethateffort shifts the distributionG(r|eO)of the
date-l income higher (in the sense of first-orderstochasticdominance).l
What is now the optimalliquiditymanagement?Intuitively,there are two ways in
which the entrepreneurcan be induced to exert effort at date O.Thefirst is standard
and consists of increasingthe entrepreneur'sstake (giving new stock options) in case
of a high date-1 income. Alternatively,the entrepreneurmay be given more liquidity
when the income is high. This means that the date-l income is not mechanistically
pumpedout (redistributedto claimholders),but is in partkept by the firmto reinvest
if needed. This yields a state-contingentcontinuationrule
p ' p*(r),
(10)
where p8( ) is an increasingfunction of the intermediateincome.

Figure6 depicts the optimalcontinuationrule as a functionof the intermediateincome for two cases. When date-Omoralhazardis light (the privategain from misbehaving is small and the date-l income is a good indicatorof managerialeffort), the
continuationrule is strictly increasing in date-l income, and it is inefficient to increase the entrepreneur'sstake in date-2 income beyond what is needed to induce
good date-1 behavior.Two new featuresappearwhen the date-Omoralhazardis substantial. First, the continuationfunction p* (r) is steeper. Second, since a cutoff
p*(r)> P1is inefficienteven in firstbest, it will be optimalto awardextrastock options to the entrepreneurafterp*(r)hits the ceiling P
p*(r)
p*(r)
pl
P1
pO
pO/Sa@-bb
/.-
r
(a) Lightmoralhazard
at date O
r
(b) Substantialmoralhazard
at date O
FIG. 6
10. The following drawsfrom Rochet and Tirole (1996), which applies the model in Holmstromand
Tirole (1998b) to peer monitoringand systemic risk.
308
On the other hand, for r small, a prescribedcontinuationrule p8(r) < pOis not
credible.The investors and the entrepreneurare better off renegotiatingthe closure
of the firm if p < pO.The entrepreneuralways prefers continuation,while the investors gain (pO-p)I. This explains the flat partof the dotted line in Figure 6(b).ll
This is just the standardsoft budget constraintproblem:the entrepreneuris optimally threatenedwith closure in case of bad performance;however,the firmmay be
illiquid but solvent, which gives the investors an incentive to renege on their commitmentand to rescue the firm.This, naturally,impactsnegativelythe entrepreneur's
initial incentive.
3. OPTIMALRISK MANAGEMENT
We have seen that, even in a world of universalrisk neutrality,firms ought to obtain some insuranceagainstliquidity shocks as long as capitalmarketimperfections
preventthem from pledging the entire value of their activity to new investors.Following Froot, Scharfstein,and Stein (1993), we can use this idea to derive an elementaryexplanationof corporatehedging.l2
In this section, we focus on optimalrisk managementwhen the investorscan observe thatthe firmis indeed hedging andthey understandthe correlationbetween the
derivativeinstrumentand the rest of the firm's portfolio. In practice,investors may
have troubleknowing whetherthe entrepreneuruses the derivativesfor hedging or
gamblingpurposes;we will study the correspondingissues in section 4.
3.1 Costless Hedging
To build intuition,let us begin with the case in which the firmcan at no cost hedge
againsta shock on its date-1 income. We extend the model of section 2 by addingan
with E(E|p) = O.For
exogenous shock E to the date-l income, which becomes r-,
example, E may representthe uncertaintyin the exchange rate of a countryin which
the firmproducesor sells. An FX derivativeallows the firmto stabilize its income to
r which, for simplicity,we assume deterministic.
It can be shown (and this will be a special case of the result obtainedin section
3.2) thatit is optimalfor the entrepreneurandthe investorsto agreetofully hedge the
risk. Intuitively,the extranoise imposes undue variationin the liquidity availableto
the firm and there is in this model no reason to create ambiguityas to the continua11. In Figure 6(b), the darkline representsthe optimal continuationpolicy when renegotiationcan be
ruled out. The optimalpolicy underrenegotiationis depictedby the dottedline.
12. Otherexplanationshave been offered in the literature.Stultz (1984) arguesthatcorporatehedging
allows managersto obtainsome insurancefor theirrisky portfolio(stock options, ....) againstshocks that
they have no control over. While this point is well taken Froot, Scharfstein,and Stein (1993) note that
managerscould obtain such diversificationby going to the correspondingmarketsthemselves, and so
Stulz' argumentrelies on a transactioncost differential.Tax reasons have also been discussed in the literature.See Smith and Stulz (1985) and Stulz (1996) for more complete discussions.
Froot, Scharfstein,and Stein (1993) assume thatcapitalmarketsare imperfect(firmsare unableto borrow or issue equity in case of a shortfall), so that "internalfinance"is cheaper than "externalfinance."
They argue that the hedging activity shifts internalfunds from excess cash scenarios towarddeficit scenarios. Ourtreatmentfollows theiridea while endogenizingthe capital marketimperfection.
tion rule. For a given amountof liquid assets, the continuationrule is p ' p* under
hedging, and p + E < pt in the absence of hedging. The absence of hedging will
lead to reinvestmentin some states of naturewith liquidity shock above pt and closure in other states with liquidity shock underp* (but higherthan p0).This is inefficient because the marginal value of liquidity decreases with p. The entrepreneur
should not be held accountablefor a shock she does not control, providedit can be
hedged at a fair rate.
Two importantremarksarein order.First,the investorsmay need to check thatthe
entrepreneurindeed hedges. For small FX shocks E the entrepreneurwants to hedge
only if the distributionof liquidity shocks F(p) is concave. For large FX shocks, the
umbrellaprovidedby the soft budget constraint(the willingness of investors to finance p < p0) makes it less likely that the entrepreneurwill want to abide by her
promise to hedge. Similarly, if information accrued to the entrepreneurbetween
dates 0 and 1 concerningthe date-1 liquidity shock p, hedging could become problematic.In case of bad news andknowing thatthe projectis unlikelyto be continued,
the entrepreneurwould want to undo the hedge in orderto "gamblefor resurrection."
Second, the readermay be puzzled by the fact thatthe entrepreneuris risk loving
with respectto reinvestmentneeds p see section 1-but risk aversewith respect to
cash-flow shocks e. The reason is that reinvestmentembodies an option value. The
firmcan forgo reinvestmentfor bad realizationsp, which makes variationin p valuable. In contrast,thereis no scope for opting out of a bad realizationof the cash-flow
shock e.
To sum up, we have arguedthatfirmsshouldbe insulatedfrom all shocks that can
be costlessly hedged in capitalmarkets.Even firmsowned and financedby risk neutral investors should purchaseinsuranceagainst fire, theft, and other indiosyncratic
events in orderto reduce the variabilityin the reinvestmentrule. Note that the interest in this fair-ratecase is limited in thatit does not make any predictionas to which
firms should hedge: They should all fully hedge indiosyncraticshocks outside the
entrepreneur'scontrol!We now extend the risk managementmodel to allow for partial hedging.
3.2 CostlyHedging
While the death of a key employee is an idiosyncraticshock, a numberof other
contingencies,such as interestrate fluctuatioIls,againstwhich the firm can hedge in
well-organizedmarkets,are macroeconomicin nature.Thus even with perfect markets, such risk cannotbe coveredat a fairrate.To the extentthatthe firm'srisk is positively correlatedwith aggregaterisk, the firmmust pay a premiumin orderto hedge.
It is then optimalfor firmsto engage in partialhedging. Intuitively,entrepreneurs/insiders should want their fair share of aggregateuncertainty.In practice,hedging by
the corporatesector is indeed quite incomplete(Culp, Miller, and Neves 1998).
Whatkinds of firms shouldhedge more?l3One potentialdeterminantis the firm's
leverage. Stulz (1996) arguesthat firms with little debt or highly rateddebt have no
13. We abstractfrom the fact that some types of hedging are subjectto increasingreturns(due in particularto the need for expertise),and so are best performedby large banksor firms.
310
need to hedge because such firms are better able to raise new funds on the capital
market in case of a liquidity shock. Scholesl4 in contrast argues that such Elrms
shouldhedge andborrowmore. One goal of this section is to revisitthis debatein the
light of our model of optimalliquiditymanagement.Importantly,a firm'sleverageis
endogenous,andmay interactwith factorsthatimpactits liquidityandhedging strategy. The same point applies to other determinantsof hedging. For example, Tufano
(1996), studying mining corporations,finds that firms in which managementhas a
bigger stake hedge more. Rationalizingthis observationrequireslooking at the factors thatimpactthe shareof management.
Let us returnto our canonicalmodel, and denoteby u ' Othe unit cost of hedging
(in section 3.1 we assumedu = 0). Thatis, to eliminaterisk eI, the firmmust pay Iu
at date 0. We will still be able to write the investors'break-evenconditionin termsof
an expected rate of return.l5Let X denote the hedging ratio (0 < X c 1). The initial
investmentthen costs (1 + Bu)I at date 0, and the firm has enough liquidity to continue at date 1 if and only if pI < [pt-e(1
-B)]I, where pt is, as earlier,the
plannedlevel of availableliquidity.
As in section 2, we allow for a (deterministicfor simplicity) date-l income rI. As
we noted there,this date-1 income in effect reducesthe per unit cost of investmentat
date 0, here to 1 + Bu-r. The aggregateshock E can be viewed as a shock on date-1
income, for example.The investors'break-evenconstraintstates that,in expectation
the investors'total outlay is equal to theirbenefit:
(1 + Bu-r)I-A
+ E[|P
) pf(p)dp] I = E[F(p 8-8(1-))]poI
*(1 1)
As usual, the entrepreneur'sutility is equal to the firm'sNPV:

[
))]plI-[1
+ Xu-r+
[lP8-(l-4P+(
)d
Let
1 + Xu- r +
'
E [I0
E[F(p 8-8(1
p+(p)dp]
))]
14. Cited on page 16 of "A Survey of CorporateRisk Management,"The Economist, February10,

1996.
15. One may think of this model as being embeddedin a model of aggregateliquidity premia, as in
Holmstromand Tirole (1998a). But it can also be embeddedin a CAPM-typemodel in which premiaare
associated with investors' risk aversion:The investors' break-evencondition can then be written in the
equivalentrisk-neutralform, with u denoting the price of aggregaterisk and the other uncertaintybeing
firm specific and diversifiedaway.
denote the unit cost of eXectiveinvestment,that is, the cost of obtaining(in expectation) one unit of unliquidatedinvestment.It is equal to the net expected investment
cost divided by the probabilityof continuation.
Using (11 ) and (12), the entrepreneur'sobjectivefilnctionis
(13)
C(p8,)_po
The extent of hedging X andthe hoardingof (other)liquiditypt aredeterminedby

a cost-minimizationprogram:
min {c(pt, ) } .
{p8 k}
This immediatelyyields the following separabilityresult:The extent, of hedging

(X) is invariantto changes in variablesthat affect only date-2 total benefit (Pl) and
pledgeableincome (p0).
Thus, suppose that moral hazard increases (B increases, and therefore p0 decreases).The entrepreneur'ssharein date-2profitgoes up, investmentis reducedand
presumablyleverage also goes down.l6 Similarly, if we identify the rating of the
long-term(date-2) debt with the probability,PH, Ofreimbursement,then the extent of
hedging is unrelatedto the ratingof the firm'sdebt.
We now turn to factors that potentially affect the firm's hedging behavior.Note
first that for u = 0, the derivativeof the cost function c with respect to the hedging
ratio X is equal to 0 at X = 1. We thus verify the intuition given in section 3.1: If
hedging is costless, the firmshouldfully hedge. On the otherhand,for u > 0, the derivativeof c at X = 1 is positive, and so partialhedging is optimal.
Ratherthan attemptinga general analysis, we specialize the model to a uniform
distribution:F(p) = p on [0, 1], say. Then
c(pt, >,)=
1 + Bu-r +-[(pe)2
2
+ (1-)2a2
Pt
where o2is the variance of e. In the uniform case, the optimal hedging ratio decreases with the ratio of the cost of hedging over the varianceof the noise, that is,
with the unit cost of hedging:
16. "Presumably"refersto the fact thatthereare severalpossible definitionsof leverage (in this model
as in reality), dependingon what is on and off the balance sheet (is the extraliquidity (p*-po)I invested
in securitiesor is it a creditline securedfrom a bank?)and on how the maturitycompositionof outsiders'
claims is accountedfor. We looked (in a non-exhaustiveway) at a couple of accountingconventions,for
which the leverageratio was indeed increasingin the pledgeableincome pO.
312
=1-
2.
T
In contrast,pt dependsalso on the date-l (expected) income r:
(p8)2
2(1-r + u) _ u
An increasein the cost of hedging u reducesthe hedging ratio and (in the relevant
rangeX ' O)decreasesthe hoardingof liquidity,(pt-r)I,
if positive. It also raises
the cost c.
Last, considerthe impactof an increasein short-termincome r. This increasedoes
not affect the hedging ratio, but increases the amountof short-termdebt per unit of
investment(r-p8), if positive.l7
To conclude, hedging may or may not depend on factors that affect other dimensions of liquiditymanagementincluding short- and long-termleverage.Any covariation between these endogenous variablesrequiresa detailed analysis of the factors
thatcreatewithin-sampleheterogeneity.
4. BANKINGREGULATIONAND RISK MANAGEMENT
4.1 Brief Overviewof the Debate

A famous accorddesignedby the Basle committeeandpassed in 1988 providesan
internationalharmonizationof prudentialrules. This accord focuses on credit risk.
Its main objectiveis to define minimumcapitalrequirementsfor the banks' on- and
off-balance-sheetactivitiesthatdependon the identity and on the value of the assets
of the borrower(government,otherbanks,privatesector, . . .). This regulationof the
banks' banking book raises a numberof practical as well as conceptual issues regardingthe natureof the risk, the lack of correlationmeasures,the choice of historical cost versus market value accounting, the incentive to securitize, and the
definitionof equity. [See DewatripontandTirole (1994) for a descriptionof the 1988
regulationsand a theoreticalanalysis of these issues.]
We will here focus on a specific but crucialissue: the treatmentof the bank'strading book and marketrisk. The tradingbook "meansthe bank's proprietarypositions
in financial instruments (including positions in derivative products and off-balance-sheet instruments)that are intentionallyheld for short-termresale and/orthat
are taken on by the bank with the intentionof benefittingin the shortterm from actual and expected differencesbetween theirbuying and selling prices, or from other
price or interestrate variations,and positions in financialinstrumentsarising from
17. The short-termdebt can alternativelybe measuredas [r-(p*-pO)]
this does not affect the conclusion.
if dilutionis permitted,but
matchedprincipalbrokeringandmarketmaking,or positions takenin orderto hedge

otherelements of the tradingbook.''l8
Derivativeproducts(for example, swaps) that are clearly intendedto hedge positions in the bankingbook can be classified by the banks as belonging to the banking
book; they are then excluded from the marketrisk measure,but become subject to
the creditrisk (counterpartydefaultrisk) capitalrequirements.
When the initial accordwas passed, it was alreadyclear to the regulatorsthat the
absence of a coherenttreatmentof marketrisk was a serious shortcoming.The 1996
amendmentto the 1988 Basle accord imposed a second capital adequacyrequirement (CAR) for the tradingbook. Banks were now subject to two separateCARs,
one on the banking book based on credit risk, and the other on the tradingbook
based on marketrisk.
The 1996 amendmenthas drawncriticism, and is viewed by its designers only as
an intermediatestep towarda betterframework.There are severalproblems.
First,it is sometimeshardto distinguishbetween creditrisk and marketrisk. Suppose a borrowerpledges real estate or equity as collateralfor a loan. The value of this
collateralis subject to significantmarketrisk. Yet, for the bank, the risk is a credit
risk (how much will the bankreceive if the borrowerdefaults?).Similarly,a loan to
a highly leveraged institution, such as Long Term Capital Management or to an
emerging country,involve a fair amount,of marketrisk, even though formally the
risk is one of counterpartydefault.As a last example, a loan take-downis not a random event in the business cycle, since borrowersare much more likely to draw on
theircreditfacilities in bad times. Some of these examples also show how conceptually difficultit can be to distinguishbetween the tradingandthe bankingbooks (even
though in practicethe division is usually quite easy since the two activities are carried out in separateunits within the bank).This raises a concern aboutusing a piecemeal approach,a concernwe will come back to.
Second, there is an issue regardingthe measurementof the trading portfolio's
overall risk. Unlike the regulationof the bankingbook, which by and large ignores
any correlationbetween its componentrisks, the capital adequacyrequirementfor
the tradingbook is meant to be based on an aggregateview of the tradingportfolio.
Measuringsuch risk requires sophisticatedeconometric techniques and good data
concerningthe volatility of the elements in the portfolio (bonds of various maturities, currencies,derivativeinstruments,etc.), of the covariancematrix,and of the effectiveness of the state-contingentportfolio reallocations.There are also problems
with using historical simulations to predict future movements, relying on a small
amountof dataaboutextremelower tail events (Gaussianapproximationshave thinner tails thanthe empiricalreturns)and choosing the time horizon.
The 1996 Amendmentspecifies a ten-dayValue-at-Risk(VaR) with a 99 percent
confidencelevel. Thatis, the capitalrequirementfor the tradingbook (to be addedto
that on the bankingbook) is proportionalto the maximumloss in the bank's portfo18. Basle Committeeon Banking Supervision(1996), Amendmentto the CapitalAccord to Incorporate MarketRisks.
314
lio that can occur within ten days with probabilitymore than 1 percent. The bank
must meet, on a daily basis, a capital requirementon the tradingbook expressed as
the higher of (i) its previous day's VaR numberand (ii) an averageof the daily VaR
numberson each of the preceding sixty business days, multipliedby a factor that is
at least 3 and can be broughtup to 4 dependingon the outcome of backtesting.
How is this VaR computed?The Basle committee allows banks to use their own
internal model, provided this model is approvedby the regulators.The approval
process is based on a numberof criteria:skill of the staff (in risk controlandback office management),trackrecord on accuracyin measuringrisk, and stress testing to
cover a range of factors than can create extraordinarylosses. The use of an internal
model is therefore a priori limited to sophisticated(and often large) banks. Other
banks use the defaultoption, the so-called "standardizedmeasurementmethod"describedin the amendment,which relies on a more prescriptiveand mechanicaltreatment of risk.
It is also worth noting that another approach, the Precommitment Approach
(PCA), originatingat the U.S. FederalReserve (see Kupiec and O'Brien l995a and
b),was proposedas an alternativeto this InternalModel Approach(IMA). The PCA
proponentsarguedthat the IMA requiressubstantialregulatoryexpertise and independence,andthatthe disclosureof the internalmodel is useful only if the risk structure is highly correlated over time. They argued in favor of a more flexible and
lighterregulatoryapproachin which the bank itself would assess its maximumpossible loss, which in turnwould determinethe capitalrequirement.Incentivecompatibility would then be ensured by ex post penalties. The PCA proposal has been
criticized on groundsthat ex post penalties are particularlylimited in situationsof
undercapitalization
We refer to Rochet (1999) for a theoreticalperspective on the relationshipbetween IMA and PCA (as Rochet notes, the PCA is an "indirectmechanism"while
the IMA is "directmechanism"in the terminology of mechanism design. The two
ought to be equivalentif the risk structurechanges quickly over time and the regulators lack expertiseto see throughinternalmodels). The criticismleveled at PCA concerningthe difficultyof implementingex post punishmentsappliesas well to IMA to
the extentthatthe inspectionof the model does not suffice to ensuretruthtelling. The
benefit of the PCA is its greaterflexibilityin letting the bank announceprivateinformationaboutfutureinnovationsin the risk structureandin relying less on regulatory
expertise and benevolence. The benefit of the IMA is that if either the risk structure
is highly correlatedover time or/andthe regulatorsare sufficientlystaffed and competent and are able to see through a complex model, backtesting and inspection
allow early action by the supervisorybody. There is then a lower reliance on a difficult ex post intervention.
19. See Daripa,Jackson,andVarotto(1997). For generaldiscussions of the dangersof and limit to ex
post penalties, see the Federal Deposit InsuranceCorporationImprovementAct (1991), Goodhartet al.
(1998), and DewatripontandTirole (1994). Monetarypenalties,public disclosuresof financialconditions,
and increases in the deposit insurancepremiumare likely to triggergambling for resurrectionor runs on
the interbankmarket.Capitalcharges, inspections, and line-of-businessrestrictionsare likely to be more
effective punishments.
4.2 WhatIs It About?

The introductionof a CAR on the tradingbook is motivatedby a concern that
large losses on the tradingbook may dry up the bank's liquidity and therebyjeopardize the bankingbook. This spillover from the tradingbook onto the bankingbook
raises the first question: Why is there a trading book in a first place? After all a
bank's proprietarytradingcould be performedthrough a separateaffiliate with no
possibility for cross-subsidizationbetween the two arms. The trading arm of the
bank would then be just anothersecurities firm.This question is rarely asked in the
debate on the prudentialregulationof marketrisk, but seems importantwhen thinking aboutdesirablerules.
There are two possible responses to the separationpoint. The firstis that there are
returnsto scale in tradingactivities,in particular,due to the need for expertise.Thus,
the knowledge used to hedge the banking book can be used for other purposes as
well. It would be interestingto measurethe extent of increasingreturnsof this kind.
Second, the tradingbook may really be abouthedging the bankingbook, or, more
precisely,aboutprovidingnon-obvioushedges that insure againstrisk of the overall
bankingportfolio (we have seen that financialtransactionsthat are clearly meant to
hedge a specific risk can be switched to the tradingbook). In our view, this is an importantargumentin favorof an integratedor "wholebank"approach.A weakerversion of this argumentis that, even if the two books are stochasticallyindependent
ratherthannegativelyrelated,the bank might still reduceits capitalrequirementsby
cross-pledgingtheiroutcomes (as in Diamond 1984).
Eitherway, it is hardto see the rationalefor a piecemeal approach:Eitherthe two
activities are unrelatedand then they are best separatedinto independententities,
which cannot cross-subsidizeeach other;or they are linked and then a whole-bank
(integrated)approachwould be preferable.
Let us pursuethis whole-bankapproachusing the second rationalefor integration:
The tradingbook serves to hedge the bankingbook. In the frameworkof this paper,
assume that the bank is subject to a dual income shock at date 1: rb on the banking
book and rton the tradingbook. We can entertainthreedifferenthypotheses:
(H1) Both rband rt are observed.
(H2) Only the sum rb + rtis observed.
(H3) rtis observed,rbis not.
In all cases, we will assume that the regulatorsare unable to verify that the bank is
hedging. Let us look at the implicationsof each hypothesis:
(H1) If both income shocks are separatelyobserved by the regulators,then the
bank should be, ceteris paribus,punished when the realizations of the shocks are
positively related and rewardedwhen they are negatively related.An implicationof
this is thatthe bank should see some of its surplusexpropriatedwhen both shocks to
the bankingbook and to the tradingbook are favorable.The amendmentin contrast
focuses on the extreme lower tail and is unable to yield discipline throughaction in
states of nature(very favorableones) in which discipline is easiest to enforce (as we
have seen, punishmentsare hardto implementwhen the bankis undercapitalized).
316
(H2) In the polar case, the regulatorcannot tell the two income shocks apart.The
bank is able to carryout transfersbetween the two books, perhapsthrougharrangements with a thirdparty such as a highly levered institution.The bank may have an
incentive to carryout such transferseither to avoid punishmentor to minimize capital charges.The scope for this fungibilitydependson what counts as hedging. In the
most narrowdefinition,there is little scope for switching income from one book to
the other.But then, of course, thereis little recognitionof the role of the tradingbook
as a hedge againstuncertaintyin the bankingbook. Conversely,a broaddefinitionof
a hedge recognizes this role, but is subjectto manipulations.
Under (H2), the regulatorsshould again adopt a whole bank approach.The difficulty is thatthe regulatorsmay not know whetherthe bank is using the financialinstruments(the tradingbook) for hedging or gamblingpurposes.
Formally,the issue is one of "doublemoralhazard."The bankaffects its income in
two ways: througheffort it shifts the distributionof income towardhigher values (in
the sense of first-orderstochastic dominance);throughrisk-takingor hedging, it affects the riskiness of the distribution(in the sense of second-orderstochastic dominance). The literatureon this type of agency problemis unfortunatelyquite small.20
Alger (1999) considers a simple example with a two-date (no liquidity shock)
structure. A risk-averse banking entrepreneurwith capital/assets A, invests an
amountI borrowingI-A at date 0, and then selects some effort e, together,possibly, with a choice of riskiness.The date-1 final income is given by
y = (e +
+ 68)I,
where E is a shock thatcan be insuredin derivativesmarkets.Regulatorslack expertise to control the bank's hedging behavior.If allowed to play with derivatives,the
bankingentrepreneurcan select to hedge (6 =-1) or to gamble (6 = + 1). So 6 is a
second dimensionof moralhazard.Alternatively,the entrepreneurmay be prohibited
from playing the derivativesgame, which automaticallyresults in 6 = O (this is
equivalentto a full separationbetween the bankingandtradingbooks in this model).
The entrepreneurhas expected utility E[U(Rf)]-g(e), where Ut ) is a concave
function of the bankingfirm'sprofitRf, and g( ) is the disutility of effort. In Alger's
example, e E {O,1}, andE E {-1,0, 1}. Entrepreneurial
risk aversionarguesin favor
of removingthe noise E throughhedging. However,the entrepreneurmay then shirk
and gamble so as to benefit from the uppertail of the distribution.Alger characterizes the minimumcapital requirementwhen derivativesare allowed and when they
are not.
Intuitionsuggests that a higher capital requirementshould be imposed when the
bankwants to use derivatives.Alger shows thatthis intuitionmay or may not be correct. The possibility of hedging may increase the signal-to-noise ratio and allow a
bettercontrolof the firstform of moralhazard.So introducingthe risk dimensionof
20. See, however,Bester and Hellwig (1987) and Bolton and Harris(1999) for structuredexamples.
moral hazard may actually help control the effort dimension of moral hazard and
lower the CAR.21
While the effect unveiled by Alger is quite robust the conclusion that a lower
CAR may be associated with the use of derivativesstill seems a bit counteractive.
The developmentof more generalframeworkscombiningboth types of moralhazard
is eagerly awaited.
(H3) Last let us considerthe case in which only rtis observed.To be certain,this
case can only be a metaphor.Regulatorsdo measurecapitalratiosfor bankingbooks
and thereforeare able to assess theirevolution.
What(H3) is a metaphorfor is a situationin which informationaboutthe banking
and tradingbooks accrue at differentfrequencies.Informationabout the quality of
loans for example accrues much more slowly than information about the market
value of the tradingbook. A more plausible (but still highly stylized) representation
of (H3) in the context of our model would then be one in which rbis learnedat date
1 while thereare two realizationsof rt (shocks on the tradingbook value) at date 1/2
and 1, say. The explorationof models in which differentportfolios (or at least their
measurabilityby the regulator)move at differentfrequenciesseems a fruitfulavenue
for research.
5. CONCLUDINGREMARKS
The paperhas developed a unified and optimalcontractingapproachto the choice

of capitalstructure,liquidity,and risk management,and theirrelationshipto the soft
budgetconstraintand free-cash-flowtheories.It has investigatedthe determinantsof
hedging and analyzed the incorporationof the marketrisk in banking regulation.
Much remainsto be done, though. As discussed in section 47 little is known about
risk managementwhen the risk structureis unknown to outsiders (investorsfor a
firm,regulatorsfor a bank).This importantpolicy issue actuallyraises a much more
general question of how to monitor a corporation'suse of liquidity.This and other
importantmicroeconomicissues concerningliquidityandrisk managementawaitfutureresearch.
LITERATURECITED
Alger, G. "The Beauty in the Beast: Derivatives, Double Moral Hazard, and Regulation."
Mimeo, GREMAQ, University of Toulouse, 1999.
Basle Committee on Banking Supervision. "Amendment to the Capital Accord to Incorporate
Market Risks." January 1996.
21. To take an extreme,if unpalatablecase, suppose thate E { 0, l }, but, unlike in Alger's paper, is a
continuousvariable.Then, y = 1 for sure under {e = 1, hedging} and with probability0 underany other
policy. Hence, any deviationfrom {e = 1, hedging} is detected with probability1, and so the use of derivativescompletely eliminatesmoralhazard(the firstbest obtains).
318
Bester, H., and M. Hellwig. "MoralHazardand EquilibriumCreditRationing:An Overview

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Spremann.Heidelberg:SpririgerVerlag, 1987.
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Crane,D. "ManagingCreditLines and Commitments."Study preparedfor the Trusteesof the
BankingResearchFundAssociation of ReserveCity Bankers,GraduateSchool of Business
Administration,HarvardUniversity,1973.
Culp, C., M. Miller, andA. Neves. "Valueat Risk: Uses andAbuses."Journalof Applied Corporate Finance 10(4) (1998), 26-38.
Daripa,A., P. Jackson,andS. Varotto."ThePre-CommitmentApproachto Setting CapitalRequirements."Bank of Englandand SIB, Financial StabilityReview(1997 Autumn),42-50.
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Liquidity and Risk Management

Author(s): Bengt Holmstrm and Jean Tirole

MONEY, CREDIT, AND

BENGT HOLMSTROMAND JEAN TIROLE : 297

The Arrow-Debreumodel, the cornerstoneof modernfinance,offers few clues for

The paperis organizedas follows: Section 1 models corporateliquiditydemandas

BENGT HOLMSTROMANDJEAN TIROLE : 299

m-ax{F(p)pHR-1-Jo pf(p)dp} > 0 *

The incentive constraintin case of continuationrequiresthat the borrower'sstake in

The break-evenconditionfor the investorsis

BENGT HOLMSTROMAND JEAN TIROLE : 301

is the marginper unit of investment.

p * minimizes c(p*) = 1+ lo Pf(p)dp

Condition(6) can be obtainedby integratingby partsandrewritingthe expected unit

This in turnimplies thatthe borrower'snet utility is

poand the expectedreturnP1

4. It is easy to show that c(-) is quasi-convex(c"(p*) > Oif c'(p*) = O).

BENGT HOLMSTROMAND JEAN TIROLE : 303

(ii) J0 G(p)dp 2 J0 F(p)dp for all p.

previously uninsurablerisk. Furthermore,(7) shows that welfare increases with an

The firstimplicationof our analysishas alreadybeen stated:because the firmmay

BENGT HOLMSTROMAND JEAN TIROLE : 305

sets thereforesell at a premiumthat economic agents must organizethe dispatching

fully pledgeable, is not equivalentto an increasein the borrower'sequityA. Such an

BENGT HOLMSTROMAND JEAN TIROLE : 307

where p8( ) is an increasingfunction of the intermediateincome.

BENGT HOLMSTROMAND JEAN TIROLE : 309

) pf(p)dp] I = E[F(p 8-8(1-))]poI

As usual, the entrepreneur'sutility is equal to the firm'sNPV:

14. Cited on page 16 of "A Survey of CorporateRisk Management,"The Economist, February10,

BENGT HOLMSTROMAND JEAN TIROLE : 311

The extent of hedging X andthe hoardingof (other)liquiditypt aredeterminedby

This immediatelyyields the following separabilityresult:The extent, of hedging

In contrast,pt dependsalso on the date-l (expected) income r:

4.1 Brief Overviewof the Debate

BENGT HOLMSTROMAND JEAN TIROLE : 313

matchedprincipalbrokeringandmarketmaking,or positions takenin orderto hedge

BENGT HOLMSTROMAND JEAN TIROLE : 315

4.2 WhatIs It About?

BENGT HOLMSTROMAND JEAN TIROLE : 317

The paperhas developed a unified and optimalcontractingapproachto the choice

Bester, H., and M. Hellwig. "MoralHazardand EquilibriumCreditRationing:An Overview

BENGT HOLMSTROMAND JEAN TIROLE : 319

Das könnte Ihnen auch gefallen

4. It is easy to show that c(-) is quasi-convex(c"(p) > Oif c'(p) = O).