Fear of Fire Sales and the Credit Freeze

Douglas Diamond and Raghuram Rajan

No 14925, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: E44 G01 G21 (search for similar items in EconPapers)
Date: 2009-04
New Economics Papers: this item is included in nep-fmk and nep-mac
Note: CF EFG IFM ME
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Citations: View citations in EconPapers (62)

Published as Fear of Fire Sales, Illiquidity Seeking, and Credit Freezes* Douglas W. Diamond and Raghuram G. Rajan The Quarterly Journal of Economics (2011) 126 (2): 557-591. doi: 10.1093/qje/qjr012

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Working Paper: Fear of fire sales and the credit freeze (2010)
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