Limited Market Power and Institutions’ Incentives in a Distressed Market

We analyze the efficiency of the liquidity flows provided to recover stability in a distressed market. Using a theoretical framework, our analysis focuses on the incentives of financial institutions, namely, the incentive for arbitrage profits, the disincentive from liquidity risk, and market manipulation incentives. We show that, depending on market conditions, financial institutions determine their optimal investment strategy based on the three incentives mentioned. This paper explains how the market restabilizes from a distressed state. The main findings are as follows: High deterioration risk and strong trend sensitivity decrease institutions’ investments; when an institution has sufficient risk-bearing capacity, it trades against a market shock, but when it does not, it follows the shock; as more funding is injected into institution, the more it invests capital in risky assets while reducing market exposure; and competition among institutions contributes to market stability stimulating institutions’ investments. Our findings help to explain financial issues such as the flight to quality, liquidity dry-ups, market manipulation, asset fire sales, and shock amplification in a distressed market. In addition, they provide important implications for policymakers endeavoring to recover market stability. We suggest that policymakers lessen the market power of a few financial institutions by spreading private information across the market at lower information costs and by stimulating competition by injecting public funds into as many institutions as possible.