Fear of Fire Sales, Illiquidity Seeking, and Credit Freezes

Is there any need to “clean” up a banking system in the midst of a crisis, for instance, by closing some weak banks and forcing others to sell bad assets, or can one wait till the crisis is over? We argue that an “overhang” of impaired banks that may be forced to sell assets in the future can increase the private returns to holding illiquid assets sufficiently that weak banks have no interest in selling them. Anticipating a potential future fire sale, cash rich buyers have high expected returns to holding cash, which also reduces their incentive to lock up money in term loans. The potential for a worse fire sale than necessary, as well as the associated decline in credit origination, could make the crisis worse, which is one reason it may make sense to clean up the system even in the midst of the crisis. We discuss alternative ways of cleaning up the system, and the associated costs and benefits.