Fire Sales in a Model of Complexity

In this paper we present a model of …re sales and market breakdowns, and of the …nancial ampli…cation mechanism that follows from them. The distinctive feature of our model is the central role played by endogenous uncertainty. As conditions deteriorate, more “banks” within the …nancial network become distressed, which increases each (non-distressed) bank’s likelihood of being hit by an indirect shock. As this happens, banks face an increasingly complex environment since they need to understand more and more interlinkages in making their …nancial decisions. Uncertainty comes as a by-product of this complexity, and makes relatively healthy banks, and hence potential asset buyers, reluctant to buy. The liquidity of the market quickly vanishes and a …nancial crisis ensues. The model features a novel complexity externality which provides a rationale for various government policies commonly used during …nancial crises, including bailouts and asset price supports. JEL Codes: G1, E0, D8, E5 Keywords: Fire sales, uncertainty, complexity, …nancial network, cascades, market freezes, crises, …nancial panic, credit crunch, externality. MIT and NBER, and Harvard University, respectively. Contact information: [email protected] and [email protected]. An earlier version of this paper has been circulated under the title, “Complexity and Financial Panics”(2009). We thank Je¤ Campbell, John Geanakoplos, David Laibson, Fred Malherbe, Juan Ocampo, Katerina Smidkova, Fernando Vega-Redondo, Adam Zawadowski; seminar participants at Boston College, Boston University, Harvard University, MIT, the University of Michigan; conference participants at AEA, Columbia University, ECB, IRFMP, MFI, MNB-CEPR, SED, CIED-Tel Aviv University for their comments; and the NSF for …nancial support. First draft: July 28, 2009.