Fear of Fire Sales and the Credit Freeze

In early 2009, the supply of credit in industrial countries appeared to decline. Could this be because bank balance sheets were “clogged” with illiquid securities? If so, why did banks not attempt to sell them? We argue that an “overhang” of impaired banks that may be forced to sell soon can reduce the current price of illiquid securities sufficiently that banks have no interest in selling. This creates high expected returns to holding cash for potential buyers and an aversion to making term loans. We discuss the implications for policies to clean up the banking system during a financial crisis.

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This paper was revised on June 11, 2009

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