TY  - JOUR
AU  - Caballero,Ricardo J.
AU  - Simsek,Alp
TI  - Fire Sales in a Model of Complexity
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 15479
PY  - 2009
Y2  - November 2009
UR  - http://www.nber.org/papers/w15479
L1  - http://www.nber.org/papers/w15479.pdf
N1  - Author contact info:
Ricardo J. Caballero
MIT
Department of Economics
Room E52-373a
Cambridge, MA 02142-1347
Tel: 617/253-0489
Fax: 617/253-6915
E-Mail: caball@mit.edu

Alp Simsek
Department of Economics
Massachusetts Institute of Technology
50 Memorial Drive, E52-251C
Cambridge, Ma. 02142
Tel: (617) 253-4836
Fax: (617) 253-1330
E-Mail: asimsek@mit.edu
AB  - Financial assets provide return and liquidity services to their holders.  However, during severe financial crises many asset prices plummet, destroying their liquidity provision function at the worst possible time.  In this paper we present a model of fire sales and market breakdowns, and of the financial amplification mechanism that follows from them.  The distinctive feature of our model is the central role played by endogenous complexity: As asset prices implode, more “banks” within the financial 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 financial decisions.  This complexity brings about confusion and uncertainty, which makes relatively healthy banks, and hence potential asset buyers, reluctant to buy since they now fear becoming embroiled in a cascade they do not control or understand.  The liquidity of the market quickly vanishes and a financial crisis ensues.  The model exhibits a powerful “complexity-externality.”  As a potential asset buyer chooses to pull back, the size of the cascade grows, which increases the degree of complexity of the environment.  This rise in perceived complexity induces other healthy banks to pull back, which exacerbates the fire sale and the cascade.
ER  -