Liquidity, Bank Runs, and Fire Sales Under Local Thinking

Abstract

In this paper, we examine the implications on banking crises when markets are populated by agents that neglect tail risks and form expectations conditioned on a favorable subset of all possible states of the economy. We find that optimal bank liquidity is lower than would be the case when banks are guided by rational expectations, and, consequently, the banking system is more vulnerable to adverse shocks, which leads to bank runs. Asset pledgeability of surviving banks is also affected so that their capacity to raise external funds for purchasing assets of distressed banks is weakened. Further, we examine the case when asset returns are correlated through securitization. In this case adverse shocks will be felt uniformly across the banking sector and banks that survive with the help of a public liquidity backstop will become risk–averse and reluctant to purchase distressed assets. We also explore a government funded asset purchase program that is implemented with an asset price target.

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