Fire Sales and Financial Fragility: The Role of the Size Distribution of the Banking Sector

Abstract

How do fire sales and financial fragility depend on the size distribution of the banking sector? We study this question in a model of financial intermediation with limited commitment. In particular, should panic behavior emerge in the large part of the financial system, the fire sale discount will be high due to the significant size of banks’ asset sales. Yet, if only a small segment of the banking system is experiencing fire sale conditions, then the limitations imposed from outside liquidity may not be as severe. Thus, differences in financial fragility across segments arise endogenously due to the different size of the deposit base and the amount of assets held. Notably, when outside liquidity is high where banks do not hold extra liquid assets, the large banking sector is more vulnerable to panics than the small market due to larger fire sale discounts. Yet, should outside liquidity be low which induces banks to hold excess liquid assets, a more liquid portfolio is held by banks in the large segment, leaving them less prone to runs. Finally, when banks in the large market hold precautionary liquidity whereas those in the small sector do not, the relative degree of fragility depends on the amount of outside liquidity and the extent of size asymmetry in the banking system.

Keywords: Bank Runs, Fire Sales, Limited Commitment, Size Distribution