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Fear of Fire Sales and the Credit Freeze

  • Douglas W. Diamond
  • Raghuram G. Rajan

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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  9. Myers, Stewart C., 1977. "Determinants of corporate borrowing," Journal of Financial Economics, Elsevier, vol. 5(2), pages 147-175, November.
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