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Liquidity, bank runs, and fire sales under local thinking

Hyun Woong Park and Thomas Bernardin

The North American Journal of Economics and Finance, 2018, vol. 46, issue C, 89-102

Abstract: We examine the implications on banking crises when markets are populated by agents that neglect tail risks and form expectations conditioned on a favorable subset of possible states of the economy. We find that optimal bank liquidity is lower than would be the case under rational expectations, and, consequently, the banking system is more vulnerable to adverse shocks, which lead to bank runs. Asset pledgeability of surviving banks is also affected so that their capacity to raise external funds for purchasing assets of distressed banks is weakened. Further, we examine the case when asset returns are correlated through securitization. In this case adverse shocks are felt uniformly across the banking sector and banks that survive with the help of a public liquidity backstop will become risk-averse and reluctant to purchase distressed assets. Finally, we explore a government funded asset purchase program, that is implemented with an asset price target.

Keywords: Bank runs; Fire sales; Bank liquidity; Banking crises; Local thinking (search for similar items in EconPapers)
JEL-codes: G01 G12 G21 G32 (search for similar items in EconPapers)
Date: 2018
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Handle: RePEc:eee:ecofin:v:46:y:2018:i:c:p:89-102