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Fire Sales in a Model of Complexity

  • Alp Simsek

    (MIT)

  • Ricardo Caballero

    (MIT)

Financial assets provide return and liquidity services to their holders. However, during severe financial crises many asset prices plummet, destroying their liquidity provision function at the worst possible time. In this paper we present a model of fire sales and market breakdowns, and of the financial amplification mechanism that follows from them. The distinctive feature of our model is the central role played by endogenous complexity: As asset prices implode, more "banks" within the financial network become distressed, which increases each (non-distressed) bank's likelihood of being hit by an indirect shock. As this happens, banks face an increasingly complex environment since they need to understand more and more interlinkages in making their financial decisions. This complexity brings about confusion and uncertainty, which makes relatively healthy banks, and hence potential asset buyers, reluctant to buy since they now fear becoming embroiled in a cascade they do not control or understand. The liquidity of the market quickly vanishes and a financial crisis ensues. The model exhibits a powerful "complexity-externality." As a potential asset buyer chooses to pull back, the size of the cascade grows, which increases the degree of complexity of the environment. This rise in perceived complexity induces other healthy banks to pull back, which exacerbates the fire sale and the cascade.

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Paper provided by Society for Economic Dynamics in its series 2010 Meeting Papers with number 620.

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Date of creation: 2010
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Handle: RePEc:red:sed010:620
Contact details of provider: Postal: Society for Economic Dynamics Christian Zimmermann Economic Research Federal Reserve Bank of St. Louis PO Box 442 St. Louis MO 63166-0442 USA
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Web page: http://www.EconomicDynamics.org/society.htm
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