The Economics of Financial Constraints: How Much Does Liquidity Cost?

Abstract

Authors:Roman Nikolaevich Bozhiya Volia National Research University The Higher School of Economics romanb-v@mail.ru

Ivan Ivanovich Rodionov National Research University The Higher School of Economics

The article introduces business liquidity concept as the third (in addition to risk and return metrics) determinant of company performance. The issues discussed include the analysis of key liquidity elements and the influence of agency costs, uncertainty and market incompleteness on financial decisions. We analyze in details the firm liquidity model based on the assumption of negative marginal rate of substitution between business value and liquidity in the situation of scarce external financing. Accounting for the complexity and novelty of the object we consider that solid analytical decomposition of corporate liquidity concept is the first worthwhile result. The breakdown into self-sufficient derivatives helps to conduct separate theoretical analysis and to find ways of managing. Approaches to the modelling of market liquidity described in the second part of the article are also of some interest. Basing on the cases that are maximally close to the current realities of financial management we analyze the consequences of breaking some key underlying assumptions of general equilibrium model. Classical corporate finance is largely based on them but post crisis economic realities don’t always support. Particularly we analyze the mechanism of costly financing under uncertainty and agency. Additional possibilities of shareholder value creation arise in incomplete markets with non-anonymous investors. From the practical application point of view it does not seem premature to discuss the fact that liquidity should gradually become a common performance metric of financial strategy and come in financial decision-making at all levels - from the board of directors to the operational financial management. With the sufficient development of a theoretical framework and experience of practical application, it would be worthwhile to incorporate liquidity, as one of the strategic development performance metrics, in to the financial reporting standards of public companies.