Fire Sales in a Model of Complexity

Abstract

In this paper we present a model of fire sales and market breakdowns, and of the financial amplification mechanism that follows from them. The distinctive feature of our model is the central role played by endogenous uncertainty. As conditions deteriorate, more “banks” within the financial network become distressed, which increases each (non-distressed) bank’s likelihood of being hit by an indirect shock. As this happens, banks face an increasingly complex environment since they need to understand more and more interlinkages in making their financial decisions. Uncertainty comes as a by-product of this complexity, and makes relatively healthy banks, and hence potential asset buyers, reluctant to buy. The liquidity of the market quickly vanishes and a financial crisis ensues. The model features a novel complexity externality which provides a rationale for various government policies commonly used during financial crises, including bailouts and asset price supports.

Keywords: Fire sales, uncertainty, complexity, financial network, cascades, market freezes, crises, financial panic, credit crunch, externality

JEL Classification: E0, G1, D8, E5