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Endogenous choice of bank liquidity: the role of fire sales

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Author Info

  • Acharya, Viral

    ()
    (London Business School)

  • Song Shin, Hyun

    ()
    (Princeton University Bendheim Center for Finance)

  • Yorulmazer, Tanju

    ()
    (Federal Reserve Bank of New York)

Abstract

Banks’ liquidity is a crucial determinant of the adversity of banking crises. In this paper, we consider the effect of fire sales and entry during crises on banks’ ex-ante choice of liquid asset holdings. We consider a setting with limited pledgeability of risky cash flows relative to safe ones and a differential expertise between banks and outsiders in employing banking assets. When a large number of banks fail, market for assets clears only at fire-sale prices and outsiders enter the market if prices fall sufficiently low. In such states, there is a private benefit of liquid holdings to banks from purchasing assets. There is also a social benefit since greater banking system liquidity reduces inefficiency from liquidation of assets to outsiders. When pledgeability of risky cash flows is high, for instance, in countries with well-developed capital markets, banks hold less liquidity than is socially optimal due to risk-shifting incentives; otherwise, banks may hold even more liquidity than is socially optimal to capitalise on fire sales. However, if there is a systemic cost associated with crises, for example, in the form of fiscal costs associated with provision of deposit insurance, then socially optimal liquidity may always be higher than the privately optimal one, and, in turn, regulation in the form of prudent liquidity requirements may be desirable. We provide some international evidence on banks’ liquid holdings that is consistent with model’s predictions.

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Bibliographic Info

Paper provided by Bank of England in its series Bank of England working papers with number 376.

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Length: 68 pages
Date of creation: 27 Nov 2009
Date of revision:
Handle: RePEc:boe:boeewp:0376

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Keywords: Crises; systemic risk; distress; limited pledgeability; lender of last resort;

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References

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Cited by:
  1. Wolf Wagner, 2009. "Efficient Asset Allocations in the Banking Sector and Financial Regulation," International Journal of Central Banking, International Journal of Central Banking, vol. 5(1), pages 75-95, March.
  2. Upper, Christian, 2011. "Simulation methods to assess the danger of contagion in interbank markets," Journal of Financial Stability, Elsevier, vol. 7(3), pages 111-125, August.
  3. Jan Willem van den End & Mark Kruidhof, 2012. "Modelling the liquidity ratio as macroprudential instrument," DNB Working Papers 342, Netherlands Central Bank, Research Department.
  4. Sujit Kapadia & Matthias Drehmann & John Elliott & Gabriel Sterne, 2012. "Liquidity Risk, Cash Flow Constraints, and Systemic Feedbacks," NBER Chapters, in: Quantifying Systemic Risk, pages 28-61 National Bureau of Economic Research, Inc.
  5. Leo de Haan & Jan Willem van den End, 2012. "Bank liquidity, the maturity ladder, and regulation," DNB Working Papers 346, Netherlands Central Bank, Research Department.

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