41 Pages Posted: 5 May 2010
Date Written: March 2010
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.
Keywords: Fire sales, illiquid securities, bank fragility, prudential policy
JEL Classification: G21, G01, G28
Suggested Citation: 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: https://ssrn.com/abstract=1599487 or http://dx.doi.org/10.2139/ssrn.1599487