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Fire Sales, the LOLR, and Bank Runs with Continuous Asset Liquidity

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Abstract

Banks' asset fire sales and recourse to central bank credit are modeled with continuous asset liquidity, allowing us to derive the liability structure of a bank. Both asset sales liquidity and the central bank collateral framework are modeled as power functions within the unit interval. Funding stability is captured as a strategic bank run game in pure strategies between depositors. Fire sale liquidity and the central bank collateral framework determine jointly the ability of the banking system to deliver maturity transformation without endangering financial stability. The model also explains why banks tend to use the least liquid eligible collateral with the central bank and why a sudden unanticipated reduction of asset liquidity, or a tightening of the collateral framework, can trigger a bank run. The model also shows that the collateral framework can be understood, beyond its aim to protect the central bank, as a financial stability and unconventional monetary policy instrument.

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  • Lanari, Edoardo, 2022. "Fire Sales, the LOLR, and Bank Runs with Continuous Asset Liquidity," Journal of Financial Crises, Yale Program on Financial Stability (YPFS), vol. 4(4), pages 77-102, April.
    • Handle: RePEc:ysm:ypfsfc:v:4:y:2022:i:4:p:77-102
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    More about this item

    Keywords

    asset liquidity; bank intermediation spreads; bank run; capital structure; collateral; fire sales; lender of last resort;
    All these keywords.

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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