Aggregate Leverage and Preemptive Selling by Individual Financial Institutions

Abstract:     
Our paper studies an economy in which each financial institution takes into account that if it has to sell its assets after others have already sold, the price will be lower. This causes preemptive selling, driven not by actual margin calls, but by the fear of future margin calls. Financial institutions cannot determine their optimal capitalizations in isolation, but need to know the aggregate capitalization. The resulting equilibrium is fragile: Small changes in model parameters can cause large changes in the equilibrium allocation of risk. Our model is a natural complement to Allen and Gale (2004).

Keywords: Leverage, Banks, Financial Institutions, Preemptive Selling, Fire Sales

JEL Classifications: G2, G31

Working Paper Series