A Theory of Endogenous Asset Fire Sales, Bank Runs, and Contagion

In a global-games framework, we endogenize asset fire sales, bank runs, and contagion by emphasizing a lack of information: investors can be uncertain whether banks selling assets to fend off runs are insolvent or simply illiquid. However, it is this uncertainty that leads to asset price collapses and runs in the first place. We show that a balanced-budget asset purchase program promotes financial stability by breaking down this vicious cycle. By contrast, increasing capital can exacerbate fire sales in the presence of adverse selection, because runs on well-capitalized banks signal high risks. We also derive implications regarding regulatory disclosure policies