Working Paper: CEPR ID: DP6309
Authors: Viral V. Acharya; Hyun Song Shin; Tanju Yorulmazer
Abstract: Bank liquidity is a crucial determinant of the severity of banking crises. In this paper, we consider the effect of fire sales and foreign entry on banks' ex ante choice of liquid asset holdings, and the ex post resolution of crises. In a setting with limited pledgeability of risky cash flows and differential expertise between banks and outsiders in employing banking assets, the market for assets clears only at fire-sale prices following the onset of a crisis -- and outsiders may enter the market if prices fall sufficiently low. While fire sales make it attractive for banks to hold liquid assets, foreign entry reduces this incentive. We exhibit international evidence on foreign entry following crises and on banks' ex ante liquidity choice that are consistent with the predictions of the model. Our framework allows us to address the key welfare question as to when there is too much or too little liquidity on bank balance sheets relative to the socially optimal level.
Keywords: crises; distress; limited pledgeability; liquidation cost; systemic risk
JEL Codes: D61; E58; G21; G28; G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Fire sales (G33) | Increased liquid asset holdings (G19) |
| Foreign entry (F23) | Decreased liquid asset holdings (G19) |
| Pledgeability of risky cash flows (G33) | Decreased liquid asset holdings (G19) |