Fear of Fire Sales, Illiquidity Seeking, and Credit Freezes

Douglas Diamond and Raghuram Rajan

The Quarterly Journal of Economics, 2011, vol. 126, issue 2, 557-591

Abstract: Is there any need to clean up a banking system by closing some banks and forcing others to sell assets if the risk of a crisis becomes high? Impaired banks that may be forced to sell illiquid assets in the future have private incentives to hold, rather than sell, those assets Anticipating a potential fire sale, liquid buyers expect high returns, reducing their incentive to lend. Privately optimal trading decisions therefore lead to a worse fire sale and a larger drop in lending than is necessary. We discuss alternative ways of cleaning up the system and the associated costs and benefits. Copyright 2011, Oxford University Press.

Date: 2011
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