Patrick Bolton, Tano Santos and Jose A. Scheinkman

The Quarterly Journal of Economics, 2011


We propose an origination-and-contingent-distribution model of banking, in which liquidity demand by short-term investors (banks) can be met with cash reserves (inside liquidity) or sales of assets (outside liquidity) to long-term investors (hedge funds and pension funds). Outside liquidity is a more efficient source, but asymmetric information about asset quality can introduce a friction in the form of excessively early asset trading in anticipation of a liquidity shock, excessively high cash reserves, and too little origination of assets by banks. The model captures key elements of the financial crisis and yields novel policy prescriptions.

View the paper here: Outside and Inside Liquidity