45 Pages Posted: 12 Dec 2008 Last revised: 31 Aug 2009
Date Written: August 28, 2009
Financial firm distress often leads to regulatory intervention, such as “too big to fail” (TBTF) policies. Two oft-cited channels to justify TBTF are domino effects (counterparty risk) and the effects of fire sales. We analyze the policy responses for avoiding systemic risk while considering the role of these two factors. Prior bankruptcies suggest that cascades caused by counterparty risk do not occur, as firms diversify their exposures. Instead, crises tend to be symptomatic of common factors in financial firms’ portfolios, which lead to widespread instances of declining asset values and which are often misinterpreted as resulting from fire sales.
Keywords: Financial institutions, systemic risk, Too big to fail, fire sales, counterparty risk
JEL Classification: G28, G33, E44, E58, E61
Suggested Citation: Suggested Citation