Market Power and Capital Constraints

We explore how traders' equity capitalization influences asset prices in a framework that accounts for market power. In our model  traders with capital constraints engage in transactions in an imperfectly competitive market. We demonstrate that looser capital constraints elevate both asset prices and price impact, which diminishes market liquidity. Using Canadian Treasury auction data, we illustrate how to apply our model to quantify these effects. We estimate the shadow costs of capital constraints by exploiting a temporary policy exemption during 2020-2021. Our analysis reveals that while these constraints are only occasionally binding, their relative  impact is sizable when activated.