Fear of fire sales and the credit freeze

Author / Creator

Diamond, Douglas W. (Douglas Warren)

Available as

Online

Summary

In early 2009, the supply of credit markets in industrial countries appeared to be tightening substantially. Was this because credit quality had deteriorated tremendously outside or inside the fina...

In early 2009, the supply of credit markets in industrial countries appeared to be tightening substantially. Was this because credit quality had deteriorated tremendously outside or inside the financial system? Or was it because bank balance sheets were "clogged" with illiquid securities? If the latter, why did banks not attempt to sell these securities? We argue in this paper that the existence of an "overhang" of impaired banks may itself reduce the price of potentially illiquid securities sufficiently that banks have no interest in selling them. In turn, this creates high expected returns to holding cash or liquid securities across the financial system and an aversion to locking up money in term loans. We discuss what this means for policies to clean up the banking system.

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