Fire Sales and Endogenous Volatility

After the collapse of the housing bubble in 2007, severe fire sales of assets in the financial sector are accompanied by a rise in the volatility of asset returns in the non-financial firms. To account for their co-movements, I develop a model that highlights the interaction between the financial health of the banking sector and the volatility of asset returns. The novel feature of the model is that the volatility of asset returns is endogenously generated by the banks’ risk taking behavior. The risk taking by banks imposes a negative externality on the financial health of other banks because given the risk aversion of secondary market buyers, the liquidation of risky assets depresses the secondary market price of assets. A weak financial health hurts the bank’s long term profitability. Combining with the limited liability, the model can give rise to a vicious feedback loop between a collective risk taking behavior in the banking sector and fire sales of assets. A standard liquidity requirement is shown to have ambiguous effects in stabilizing the financial system depending on the asset market liquidity. The model suggests a room for counter-cyclical macro-prudential policy to improve financial stability. I am deeply indebted to Christophe Chamley for his constant support and advice during this project. I also benefitted greatly from Dirk Hackbarth, Jianjun Miao, Simon Gilchrist, Stephen Terry and Anton Korinek. Comments are welcome. Email address: [email protected].