Research / BFI Working Paper•Jan 25, 2021
Liquidity, Pledgeability, and the Nature of Lending
Douglas W. Diamond, Yunzhi Hu, Raghuram Rajan
We develop a theory of how corporate lending and financial intermediation change based on the fundamentals of the firm and its environment. We focus on the interaction between the prospective net worth or liquidity of an industry and the firm’s internal governance or pledgeability. Variations in prospective liquidity can induce changes in the nature, covenants, and quantity of loans that are made, the identity of the lender, and the extent to which the lender is leveraged. We offer predictions on how these might vary over the financial cycle.