Fear of Fire Sales and the Credit Freeze

41 Pages Posted: 29 Apr 2009  

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)

Multiple version iconThere are 2 versions of this paper

Date Written: April 2009

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.

Suggested Citation

Diamond, Douglas W. and Rajan, Raghuram G., Fear of Fire Sales and the Credit Freeze (April 2009). NBER Working Paper No. w14925. Available at SSRN: https://ssrn.com/abstract=1394832

Douglas W. Diamond (Contact Author)

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/

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Raghuram G. Rajan

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)

Paper statistics

Downloads
150
Rank
63,663
Abstract Views
1,893