Fire Sales and Liquidity Requirements

Yuteng Cheng and Roberto Robatto

Staff Working Papers from Bank of Canada

Abstract: We study liquidity requirements in a framework with fire sales. The framework nests three common pricing mechanisms—cash-in-the-market, second-best-use, and adverse selection—and can produce the same observables under different pricing mechanisms. We identify three forces that shape the optimal policy. Absent risk-sharing considerations, the equilibrium is efficient with cash-in-the-market pricing; a liquidity requirement is optimal with second-best-use pricing; and a liquidity ceiling (i.e., a cap on liquid assets) is optimal with adverse selection. Accounting for risk-sharing considerations, we find the optimal level of liquidity remains higher with second-best-use pricing relative to cash-in-the-market pricing, and a liquidity ceiling remains optimal with adverse selection.

Keywords: Asset pricing; Financial markets; Financial system regulation and policies (search for similar items in EconPapers)
JEL-codes: G12 G23 G28 (search for similar items in EconPapers)
Pages: 58 pages
Date: 2024-05
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Persistent link: https://EconPapers.repec.org/RePEc:bca:bocawp:24-18

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