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Fear of Fire Sales, Illiquidity Seeking, and Credit Freezes

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  • Douglas W. Diamond
  • Raghuram G. Rajan

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.

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File URL: http://hdl.handle.net/10.1093/qje/qjr012
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Bibliographic Info

Article provided by Oxford University Press in its journal The Quarterly Journal of Economics.

Volume (Year): 126 (2011)
Issue (Month): 2 ()
Pages: 557-591

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Handle: RePEc:oup:qjecon:v:126:y:2011:i:2:p:557-591

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