Financial Stability with Fire Sale Externalities

Ryuichiro Izumi and Yang Li ()
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Yang Li: Nankai University

No 2021-002, Wesleyan Economics Working Papers from Wesleyan University, Department of Economics

Abstract: Do policies that aim to mitigate firre sale externalities 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 ineciently large fire sales in a crisis. Regulating banks' short-term liabilities and portfolio choices can mitigate this externality. We show, however, that in economies with high market liquidity, such interventions actually increase financial fragility. In such a case, policymakers must balance the desire to mitigate the externality with financial stability considerations.

Keywords: Fire sale; Pecuniary externalities; Macroprudential policies; Financial fragility (search for similar items in EconPapers)
JEL-codes: E44 G21 G28 (search for similar items in EconPapers)
Pages: 54 pages
Date: 2021-05
New Economics Papers: this item is included in nep-ban, nep-cba and nep-mac
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Persistent link: https://EconPapers.repec.org/RePEc:wes:weswpa:2021-002

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