Safe but fragile: Information acquisition, liquidity support and redemption runs

Abstract

This paper proposes a theory of redemption runs based on strategic information acquisition by fund managers. We argue that liquidity lines provided by third parties can be a source of financial fragility, as they incentivize fund managers to acquire private information about the value of their assets. This strategic information acquisition can lead to inefficient market liquidity dry-ups caused by self-fulfilling fears of adverse selection. By lowering asset prices, information acquisition also reduces the value of funds’ assets-under-management and may spur inefficient redemption runs by investors. Two different regimes can arise: one in which funds’ information acquisition incentives are unaffected by the volume of redemptions, and another where market and funding liquidity risk mutually reinforce each other.