Fire Sales, Foreign Entry and Bank Liquidity

Abstract

Bank liquidity is a crucial determinant of the severity of banking crises. We consider the effect of fire sales and foreign entry during crises on banks' ex-ante choice of liquid asset holdings. In a setting with limited pledgeability of risky cash flows and differential expertise between banks and outsiders in employing banking assets, the market for assets clears only at fire-sale prices following the onset of a crisis - and outsiders may enter the market if prices fall sufficiently low. While fire sales make it attractive for banks to hold liquid assets, foreign entry reduces this incentive. We show that in this setting, bank liquidity is counter-cyclical whereas bank capital measured as bank profits is pro-cyclical. We derive conditions under which privately optimal levels of bank liquidity are higher or lower than benchmark levels that maximize total output of the banking sector. We present and discuss evidence on bank liquidity that is consistent with model predictions.