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Fire Sales and Liquidity Requirements

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  • Yuteng Cheng
  • Roberto Robatto

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.

Suggested Citation

  • Yuteng Cheng & Roberto Robatto, 2024. "Fire Sales and Liquidity Requirements," Staff Working Papers 24-18, Bank of Canada.
    • Handle: RePEc:bca:bocawp:24-18
    DOI: 10.34989/swp-2024-18
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    References listed on IDEAS

    as
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    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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