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Fear of Fire Sales and the Credit Freeze

41 Pages Posted: 5 May 2010  

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: March 2010

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.

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

JEL Classification: G21, G01, G28

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

Douglas W. Diamond

University of Chicago - Booth School of Business ( email )

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HOME PAGE: http://faculty.chicagobooth.edu/douglas.diamond/

National Bureau of Economic Research (NBER)

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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 )

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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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