Abstract
Most treatments of financial regulation worry about threats to the banking system and the economy from defaults or credit crunches. This paper argues that the recent crisis points to fire sales through capital markets as another source of financial and economic instability. Accounting for fire sales implies several changes to the standard approach. First, if there are three channels of instability, then three regulatory tools are needed to deliver stability. Second, if only a single capital tool and a single liquidity tool are available, then there is a risk that using them pushes activity into the shadow banking system. Third, liquidity requirements on the asset side of bank balance sheets are conceptually different from liquidity requirements on the liability side. The paper starts with a review of the recent theoretical work on fire sales that form the building blocks for a next generation of models of the financial system. A summary of some evidence suggesting that fire sales were present in the crisis is offered. Next, the paper outlines a general equilibrium framework that can be used to think about a financial system in which default, credit crunches, and fire sales are all possible. The paper concludes with a discussion of the regulatory options and some speculation on how such a framework could be extended.
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Notes
Similar assessments are offered by French and others (2010) and the U.S. Treasury (2009).
As they point out, if there is uncertainty about how long the bubble persists, the incentives to securitize become even more powerful because then the option to securitize at even higher prices comes into play.
Our existing model rule out the possibility of the bank simply raising enough capital to replace the capital lost as a result of the default. It is possible to complicate the model to allow this, but the structure of the model implies that as long as there are some rising marginal costs of raising outside equity, such as adverse selection, then banks will not immediately want to make up all the losses. Tsomocos (2003), working with a variant of this model, goes a step in this direction by allowing secondary market trading in equity after losses are realized. With rational expectations the secondary market prices are anticipated by the bank so it understands there is a risk of undercapitalization. Consequently we do not see this restriction as a problem.
There is a possible indirect effect whereby the bank holds more liquid assets but also securitizes more loans than it would otherwise, but in the numerical experiments we have considered this effect is inconsequential.
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Additional information
*Anil K Kashyap is a professor at the University of Chicago Booth School of Business, a research associate at the National Bureau of Economic Research and a consultant at the Federal Reserve Bank of Chicago. Berner was co-head of Global Economics at Morgan Stanley at the time the article was written. Charles A.E. Goodhart is a professor emeritus at the London School of Economics. Prepared for the Mundell-Fleming Lecture for International Monetary Fund Annual Research Conference. The authors thank Douglas Diamond, Martin Hegarty, Carolina Osorio, Jeremy Stein, Michael Pond, Dimitrios Tsomocos, Alex Vardoulakis, Rob Vishny, and Mihir Worah for helpful conversations. Kashyap thanks the Initiative on Global Market and the Center for Research on Securities Prices at Chicago Booth for research support. The views expressed are those of the authors alone and not necessarily those of the institutions with which they are affiliated. All errors are the authors’ own.