Leverage and preemptive selling of financial institutions |
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| Institution: | 1. Federal Reserve Board of Governors, United States;2. Princeton University, United States;1. Wharton School, University of Pennsylvania, 3620 Locust Walk, Philadelphia, PA 19104, USA;2. Leeds School of Business, University of Colorado at Boulder, 995 Regent Drive, Boulder, CO 80302, USA;1. Florida Atlantic University, Boca Raton, FL 33431, United States;2. University of Wisconsin-Milwaukee, Milwaukee, WI 53211, United States;3. U.S. Securities and Exchange Commission, Washington, D.C., 20549, United States;1. University of Mannheim, Finance Area, L9 1–2, 68161 Mannheim, Germany;2. Centre for Financial Research, Cologne, Germany |
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| Abstract: | In our model, financial firms’ leverage choices and asset sales impose negative externalities on other financial firms. This means that individual firms cannot determine their optimal capitalizations in isolation, but have to take the aggregate financial sector characteristics into account. In particular, they become more aggressive when their peers are more conservative. Furthermore, financial firms over-consume liquidity in equilibrium. For some parameter regions, small parameter changes can induce large differences in the equilibrium allocation of risk. Historical experience is not necessarily a good guide as to whether the prevailing equilibrium is fragile or not. |
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