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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.

Suggested Citation

  • Douglas W. Diamond & Raghuram G. Rajan, 2009. "Fear of Fire Sales and the Credit Freeze," NBER Working Papers 14925, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:14925
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    More about this item

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G01 - Financial Economics - - General - - - Financial Crises
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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