We build a model of the financial sector to explain why adverse asset shocks in good economic times lead to a sudden drying up of liquidity. Financial firms raise short-term debt in order to finance asset purchases. When asset fundamentals worsen, debt induces firms to risk-shift; this limits...

We build a model of the financial sector to explain why adverse asset shocks in good economic times lead to a sudden drying up of liquidity. Financial firms raise short-term debt in order to finance asset purchases. When asset fundamentals worsen, debt induces firms to risk-shift; this limits...

We consider a moral hazard setup wherein leveraged firms have incentives to take on excessive risks and are thus rationed when they attempt to roll over debt. Firms can sell assets to alleviate rationing. Liquidated assets are purchased by non-rationed firms but their borrowing capacity is also...