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Liquidity,bank runs,and fire sales under local thinking
Institution:1. St. Olaf College, Department of Economics, United States;2. Denison University, Department of Economics, United States;1. School of Finance, Jiangxi University of Finance and Economics, Nanchang, China;2. School of Finance, Shanghai University of Finance and Economics, Shanghai, China;3. School of Economics, Shanghai University of Finance and Economics, Shanghai, China;1. The Australian National University, Australia;2. Macquarie University, Australia;3. Edith Cowan University, Australia;1. Department of Quantitative Methods, Faculty of Economics, University of Split, Cvite Fiskovi?a 5, Split, Croatia;2. Department of Finance, Faculty of Economics, University of Split, Cvite Fiskovi?a 5, Split, Croatia;1. College of Business, Korea Advanced Institute of Science and Technology, 85 Hoegiro, Dongdaemoon-gu, Seoul 02455, South Korea;2. Department of Accounting and Finance, Strathclyde Business School, University of Strathclyde, Glasgow G4 0QU, UK
Abstract:We examine the implications on banking crises when markets are populated by agents that neglect tail risks and form expectations conditioned on a favorable subset of possible states of the economy. We find that optimal bank liquidity is lower than would be the case under rational expectations, and, consequently, the banking system is more vulnerable to adverse shocks, which lead to bank runs. Asset pledgeability of surviving banks is also affected so that their capacity to raise external funds for purchasing assets of distressed banks is weakened. Further, we examine the case when asset returns are correlated through securitization. In this case adverse shocks are felt uniformly across the banking sector and banks that survive with the help of a public liquidity backstop will become risk-averse and reluctant to purchase distressed assets. Finally, we explore a government funded asset purchase program, that is implemented with an asset price target.
Keywords:Bank runs  Fire sales  Bank liquidity  Banking crises  Local thinking  G01  G12  G21  G32
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