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

TL;DR

This paper models bank asset fire sales and central bank credit as continuous liquidity processes, analyzing their impact on bank stability, liquidity management, and the potential for bank runs within a strategic game framework.

Contribution

It introduces a continuous asset liquidity model incorporating collateral frameworks, providing new insights into bank run triggers and the role of collateral in financial stability.

Findings

Asset fire sale liquidity and collateral frameworks jointly influence bank stability.

Sudden reductions in asset liquidity can trigger bank runs.

Collateral frameworks serve as tools for financial stability and monetary policy.

Abstract

Bank's asset fire sales and recourse to central bank credit are modelled with continuous asset liquidity, allowing 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 non-anticipated 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 financial stability and non-conventional monetary policy instrument.