Financial Stability with Fire Sale Externalities

54 Pages Posted: 28 Jan 2022

See all articles by Ryuichiro Izumi

Ryuichiro Izumi

Wesleyan University

Yang Li

NanKai University

Date Written: January 22, 2022

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

Suggested Citation

Izumi, Ryuichiro and Li, Yang, Financial Stability with Fire Sale Externalities (January 22, 2022). Available at SSRN: https://ssrn.com/abstract=4014945 or http://dx.doi.org/10.2139/ssrn.4014945

Ryuichiro Izumi (Contact Author)

Wesleyan University ( email )

Middletown, CT 06459
United States

HOME PAGE: http://www.ryuichiroizumi.com

Yang Li

NanKai University ( email )

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