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http://ssrn.com/abstract=1599487
 
 

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Fear of Fire Sales and the Credit Freeze


Douglas W. Diamond


University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER)

Raghuram G. Rajan


University of Chicago - Booth School of Business; International Monetary Fund (IMF); National Bureau of Economic Research (NBER)

March 2010

BIS Working Paper No. 305

Abstract:     
Is there any need to “clean” up a banking system in the midst of a crisis, by closing or recapitalizing weak banks and taking bad assets off bank balance sheets, or can one wait till the crisis is over? We argue that an “overhang” of impaired banks that may be forced to sell assets soon can reduce the current price of illiquid assets sufficiently that weak banks have no interest in selling them. Anticipating a potential future fire sale, cash rich buyers have high expected returns to holding cash, which also reduces their incentive to lock up money in term loans. The potential for a worse fire sale than necessary, as well as the associated decline in credit origination, could make the crisis worse, which is one reason it may make sense to clean up the system even in the midst of the crisis. We discuss alternative ways of cleaning up the system, and the associated costs and benefits. See also, http://ssrn.com/abstract=1699600.

Number of Pages in PDF File: 41

Keywords: Fire sales, illiquid securities, bank fragility, prudential policy

JEL Classification: G21, G01, G28

working papers series


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Date posted: May 5, 2010  

Suggested Citation

Diamond, Douglas W. and Rajan, Raghuram G., Fear of Fire Sales and the Credit Freeze (March 2010). BIS Working Paper No. 305. Available at SSRN: http://ssrn.com/abstract=1599487 or http://dx.doi.org/10.2139/ssrn.1599487

Contact Information

Douglas W. Diamond
University of Chicago - Booth School of Business ( email )
5807 S. Woodlawn Avenue
Chicago, IL 60637
United States
773-702-7283 (Phone)
HOME PAGE: http://faculty.chicagobooth.edu/douglas.diamond/

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National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Raghuram G. Rajan (Contact Author)
University of Chicago - Booth School of Business ( email )
5807 S. Woodlawn Avenue
Chicago, IL 60637
United States
773-702-4437 (Phone)
773-702-0458 (Fax)
International Monetary Fund (IMF) ( email )
700 19th Street NW
Washington, DC 20431
United States
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
773-702-9299 (Phone)
773-702-0458 (Fax)
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