A Theory of Endogenous Asset Fire Sales, Bank Runs, and Contagion

In a global-games framework, we endogenize asset fire sales, bank runs, and contagion by emphasizing a lack of information: Investors can be uncertain whether banks selling assets to fend off runs are insolvent or simply illiquid. However, it is this uncertainty that leads to asset price collapses and runs in the first place. We show that a balanced-budget asset purchase program promotes financial stability by breaking down this vicious circle. By contrast, increased capital can exacerbate fire sales in the presence of adverse selection, because runs on well-capitalized banks signal high risks. We also derive implications regarding regulatory disclosure policies.

Keywords: Bank run, Global games, Asymmetric information, Capital, Asset purchase program

JEL Classification: G01, G11, G21

Suggested Citation: Suggested Citation

Li, Zhao and Ma, Kebin, A Theory of Endogenous Asset Fire Sales, Bank Runs, and Contagion (March 15, 2017). Paper presented at Conference on Systemic Risk and the Organization of the Financial System, Chapman University, May 13, 2017, Available at SSRN: https://ssrn.com/abstract=3047560 or http://dx.doi.org/10.2139/ssrn.3047560