Financial Stability with Fire Sale Externalities

Abstract

Do policies that aim to mitigate fire sale externalities actually improve financial stability? We study this question in a model of financial intermediation where banks may sell long-term assets in financial markets subject to cash-in-the-market pricing and bank runs. In the absence of interventions, banks hold more long-term assets than is socially optimal, leading to inefficiently large fire sales in a crisis. Policymakers may regulate banks' choices to mitigate this externality, but lack commitment. We show that, in economies with high market liquidity, such actions have the unintended consequence of increasing fragility and lowering welfare.

Keywords: Fire sale externalities, Macroprudential regulations, Limited commitment, Financial fragility

JEL Classification: G21, E61, G28, E44