Financial Stability with Fire Sale Externalities

Do policies that aim to mitigate firre sale externalities improve financial stability? We study this question in a model of financial intermediation where banks may sell long-term assets in financial markets subject to cash-in-the-market pricing and bank runs. In the absence of interventions, banks hold more long-term assets than is socially optimal, leading to ineciently large fire sales in a crisis. Regulating banks' short-term liabilities and portfolio choices can mitigate this externality. We show, however, that in economies with high market liquidity, such interventions actually increase financial fragility. In such a case, policymakers must balance the desire to mitigate the externality with financial stability considerations.