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Fear of Fire Sales and the Credit Freeze

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  • Douglas W. Diamond
  • Raghuram G. Rajan

Abstract

Is there any need to “clean” up a banking system in the midst of a crisis, by closing or recapitalizing weak banks and taking bad assets off bank balance sheets, or can one wait till the crisis is over? We argue that an “overhang” of impaired banks that may be forced to sell assets soon can reduce the current price of illiquid assets sufficiently that weak banks have no interest in selling them. Anticipating a potential future fire sale, cash rich buyers have high expected returns to holding cash, which also reduces their incentive to lock up money in term loans. The potential for a worse fire sale than necessary, as well as the associated decline in credit origination, could make the crisis worse, which is one reason it may make sense to clean up the system even in the midst of the crisis. We discuss alternative ways of cleaning up the system, and the associated costs and benefits.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 14925.

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Date of creation: Apr 2009
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Publication status: published as Fear of Fire Sales, Illiquidity Seeking, and Credit Freezes* Douglas W. Diamond and Raghuram G. Rajan The Quarterly Journal of Economics (2011) 126 (2): 557-591. doi: 10.1093/qje/qjr012
Handle: RePEc:nbr:nberwo:14925

Note: CF EFG IFM ME
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  1. Gary Gorton, 2009. "Information, Liquidity, and the (Ongoing) Panic of 2007," American Economic Review, American Economic Association, vol. 99(2), pages 567-72, May.
  2. Jensen, Michael C. & Meckling, William H., 1976. "Theory of the firm: Managerial behavior, agency costs and ownership structure," Journal of Financial Economics, Elsevier, vol. 3(4), pages 305-360, October.
  3. Tobias Adrian & Hyun Song Shin, 2008. "Financial intermediary leverage and value at risk," Staff Reports 338, Federal Reserve Bank of New York.
  4. Ricardo J. Caballero & Arvind Krishnamurthy, 2009. "Global Imbalances and Financial Fragility," NBER Working Papers 14688, National Bureau of Economic Research, Inc.
  5. Douglas W. Diamond & Raghuram G. Rajan, 2001. "Liquidity Risk, Liquidity Creation, and Financial Fragility: A Theory of Banking," Journal of Political Economy, University of Chicago Press, vol. 109(2), pages 287-327, April.
  6. Péter Kondor, 2009. "Risk in Dynamic Arbitrage: The Price Effects of Convergence Trading," Journal of Finance, American Finance Association, vol. 64(2), pages 631-655, 04.
  7. Viral V. Acharya & Douglas Gale & Tanju Yorulmazer, 2011. "Rollover Risk and Market Freezes," Journal of Finance, American Finance Association, vol. 66(4), pages 1177-1209, 08.
  8. Douglas W. Diamond & Raghuram Rajan, 2009. "The Credit Crisis: Conjectures about Causes and Remedies," NBER Working Papers 14739, National Bureau of Economic Research, Inc.
  9. Shleifer, Andrei & Vishny, Robert W, 1992. " Liquidation Values and Debt Capacity: A Market Equilibrium Approach," Journal of Finance, American Finance Association, vol. 47(4), pages 1343-66, September.
  10. Markus K. Brunnermeier, 2009. "Deciphering the Liquidity and Credit Crunch 2007-2008," Journal of Economic Perspectives, American Economic Association, vol. 23(1), pages 77-100, Winter.
  11. Franklin Allen & Douglas Gale, 2004. "Financial Intermediaries and Markets," Econometrica, Econometric Society, vol. 72(4), pages 1023-1061, 07.
  12. Allen, Franklin & Carletti, Elena, 2008. "The role of liquidity in financial crises," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 379-412.
  13. Myers, Stewart C., 1977. "Determinants of corporate borrowing," Journal of Financial Economics, Elsevier, vol. 5(2), pages 147-175, November.
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