Fire Sales and Bank Runs in the Presence of a Saving Allocation by Depositors

In this paper, we introduce a new mechanism into a banking model featuring distressed sale of assets (fire sales). As in reality, depositors choose between the liquid deposits of banks and the illiquid assets of funds from which early withdrawals are not possible. Our model reflects that dynamics, showing that two inefficiencies arise due to a pecuniary externality. The first inefficiency is well-known: banks do not keep enough liquidity buffers. The second inefficiency is that depositors do not invest the optimal amount into institutions that can be subject to runs (banks) relative to institutions that are preserved from runs (such as pension funds). To investigate whether there is too much deposits in banks or in pension funds, the direction of the inefficiency is studied numerically. Simulations show that the banking sector can be too big relative to pension funds, and that liquidity ratios -aimed at making banks less riskycan decrease welfare by increasing incentives to deposit into banks.