Bank Runs, Fire-Sales, and Equity Injections

I present a general equilibrium model of banking in which financial crises can be due to panics (i.e., coordination failures that give rise to multiple equilibria) or fundamentals. Crises are systemic, in the sense that many banks are insolvent and subject to runs. A financial crisis is also characterized by a flight to safety-liquidity, and by sales of assets by banks at a depressed price, that is, a fire-sale. Fire-sales arise despite all agents have the same ability in managing assets (contrary to the common assumption of having “nonspecialists” who have less expertise in managing assets) and despite no liquidation cost is paid when an asset is sold. Motivated by the large intervention of the US government in October 2008, I use the model to study equity injections into banks. Large equity injections eliminate a banking crisis. However, if the policy intervention is not large enough, it amplifies the flight to safety-liquidity and (preliminary results show that it also) reduces welfare. ⇤E-mail: [email protected]. I am grateful to Briana Chang, Dean Corbae, and participants to seminars at the University of Wisconsin-Madison for comments. 1