Financial Stability with Fire Sale Externalities

Wed, 01 Jan 2025 00:00:00 +0000

Research question and motivation: Asset fire sales were a defining feature of the 2007-08 crisis, and post-crisis reforms (Basel III liquidity requirements, Money Market Mutual Fund reforms) were introduced to mitigate fire sale externalities by reducing distressed debt obligations and forcing larger liquidity buffers. The paper asks whether policies that successfully mitigate fire sale externalities actually improve financial stability, since it is not obvious how banks re-optimize in response.

Model setup (no empirical data — this is a theoretical paper): The authors build a three-period (t = 0,1,2) Diamond-Dybvig (1983) model of financial intermediation augmented with (i) cash-in-the-market pricing in a financial market as in Allen and Gale (1998), and (ii) limited commitment as in Ennis and Keister (2009), following Li (2017). A unit continuum of ex ante identical depositors have CRRA preferences with relative risk aversion γ > 1. Each depositor is impatient with known probability π. There are two assets: a short-term storage asset (1 unit yields 1 next period) and a long-term asset (1 unit at t=0 yields R > 1 at t=2). The bank invests fraction x in the long-term asset and 1−x short. Long-term assets can be sold at t=1 at an endogenous price p to risk-neutral investors who receive endowment ws (market liquidity) and have outside return R* > 0. Runs are introduced via a sunspot s ∈ {α, β} with run probability q; runs are partial (stop after fraction π is served), following Ennis and Keister. The authors assume R* = R, which implies p ≤ 1 in equilibrium. Financial fragility is measured by q-bar, the maximum run probability q for which the run strategy is an equilibrium (run condition c1 ≥ c2β).

Payment Flows, Bank Lending, and Central Bank Digital Currencies

This paper examines how the degree of user anonymity built into a central bank digital currency (CBDC) affects bank lending decisions and what this implies for the optimal design of CBDC anonymity. “Anonymity” in the paper’s sense is the lender’s inability to discern whether a borrowing entrepreneur is diverting funds—a moral hazard problem that arises because CBDC transactions, if unobservable to lending banks, prevent the screening that banks currently perform using deposit (card-based) transaction records. In a signaling model where entrepreneurs choose a payment instrument to influence bank refinancing decisions, moderate CBDC anonymity is shown to produce an inefficient pooling equilibrium in which both high- and low-quality borrowers choose CBDC, preventing banks from screening. To avoid this pooling inefficiency, CBDC anonymity should be set either low—making CBDC less attractive to entrepreneurs seeking to obscure diversion—or high—discouraging bank lending through CBDC entirely—with high anonymity optimal when CBDC significantly benefits sales, and low anonymity otherwise. Competition between bank deposits and CBDC may impede the implementation of the low-anonymity optimum.

Ryuichiro Izumi | Macro Paper Warehouse

Financial Stability with Fire Sale Externalities

Payment Flows, Bank Lending, and Central Bank Digital Currencies