Financing Capacity and Fire Sales: Evidence from Bank Failures

Abstract

Theory suggests the reduction in financing capacity after the failure of a financial intermediary can reduce the value of financial assets. Forced sales of the intermediary’s assets could consume liquidity, depressing the liquidation value of the assets of healthy intermediaries and causing contagious runs. This paper investigates these predictions using a new dataset of bank failures during the farm depression just before the Great Depression. Using regulatory impediments to lending across state borders as a means of identification, we find that the reduction in local financing capacity as a result of bank failures reduces the recovery rates on failed assets of nearby banks, depresses local land prices, renders land markets illiquid, and is associated with subsequent financial sector distress among nearby banks. All this indicates a rationale for why bank failures are contagious.