Information Acquisition and Liquidity Dry-Ups

We analyze a novel feedback mechanism between market and funding liquidity that causes self-ful lling liquidity dry-ups. Financial rms facing funding withdrawals have an incentive to acquire information about their assets. Those with good assets gain by resorting to outside liquidity sources and withhold assets from secondary markets. This leads to adverse selection and lowers market prices. If prices fall by enough, funding withdrawals are ampli ed and market and funding illiquidity become mutually reinforcing. We compare di erent policy measures that can mitigate the risk of inecient liquidity dry-ups. While outright debt purchases can implement the ecient allocation, liquidity injections may back re and exacerbate adverse selection.