Working Paper: NBER ID: w15479
Authors: Ricardo J. Caballero; Alp Simsek
Abstract: 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.
Keywords: Fire Sales; Market Complexity; Financial Crises
JEL Codes: D80; E50; G21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Asset prices decline (G19) | Likelihood of banks experiencing indirect shocks increases (F65) |
| Fire sales (G33) | Downward spiral in asset prices (G19) |
| Distressed banks sell assets (G21) | Further depresses market prices (G19) |
| As prices fall (E31) | More banks become distressed (G21) |
| More banks become distressed (G21) | Likelihood of indirect shocks across the network increases (F65) |
| Complexity of the financial environment increases (G19) | Difficulties in assessing counterparty risks (G33) |
| Difficulties in assessing counterparty risks (G33) | Reluctance to buy distressed assets (G33) |
| Decision of one bank to withdraw from the market (G21) | Exacerbates the situation for others (H84) |
| Increased overall market complexity and uncertainty (F69) | Decrease in market liquidity (E44) |
| Decrease in market liquidity (E44) | Potential insolvencies (G33) |
| Complexity perceived by banks (G21) | Influences their behavior (C92) |