An important role of capital and liquidity regulations for financial institutions is to counteract inefficiencies associated with “fire-sale externalities,” such as the tendency of institutions to lever up and hold illiquid assets to the extent that their collective actions increase financial vulnerabilities. However, theoretical models that study such externalities commonly assume perfect competition among financial institutions, in spite of high (and increasing) financial sector concentration. In this post, which is based on our forthcoming article, we consider instead how the effects of fire-sale externalities change when financial institutions have market power.
What Do Standard Models Have to Say About Fire-Sale Externalities?
An externality arises when a firm’s (or consumer’s) behavior affects others but the firm does not take those effects into account when considering its own actions. Fire-sale externalities occur when a firm’s sales of assets affect their prices, with potentially detrimental consequences for others. For example, a bank creates fire-sale externalities when it levers up to make illiquid loans but does not take into account that, should it have to sell those loans to repay its creditors, the sales will depress prices, affecting other institutions with similar assets.
Standard models that assume perfectly competitive firms often show that fire-sale externalities lead to inefficiently high levels of leverage (for example, Lorenzoni, 2008) and of illiquid assets (for example, Allen and Gale, 2004) because firms do not internalize how their investment decisions today affect fire-sale prices at a later date when they may have to sell. In reality, however, firms do not operate in perfectly competitive environments, raising the possibility that they internalize price impacts in asset markets. In fact, industry concentration has increased substantially over recent decades, both in the real and in the financial sector. In the real sector, increased concentration is manifested in decreased competition, increased markups, and declining entry and exit rates (Gutiérrez and Philippon, 2018). In the financial sector, the share of total bank assets held by the five largest banks is 47 percent in the United States and between 71 percent and 84 percent in the United Kingdom, France, Germany, Italy, and Canada (Corbae and Levine, 2018). More than 90 percent of the notional amount of derivative contracts is accounted for by five banks (OCC, 2018).
In the standard models, the fire-sale externality would be reduced if firms internalized their effects on prices: Firms would invest in less capital (that is, borrow less) or invest in fewer illiquid assets (that is, hold more liquidity), so that asset prices would fall less when they are forced to sell. In our forthcoming article, we show that the intuition of market power reducing the inefficiency of fire-sale externalities is not robust. Instead of being mitigated, the inefficiency can be either overcorrected or even exacerbated so that industry concentration might make fire sales worse.
How Can Market Power Have Perverse Effects on Fire Sales?
Whether market power mitigates or exacerbates fire sales depends on the mechanism that causes fire sales and whether it forces firms to liquidate some or all of their assets. In one common theoretical setting, fire sales occur when firms’ investments do not pay off as much as expected, which forces the firms to sell some of their illiquid assets to repay their debt. In another common setting, fire sales occur when firms face runs from their creditors, which forces the firms to sell all of their illiquid assets.
Relative to the standard models, we assume imperfect “Cournot” competition where firms take into account their effects on asset prices in a future fire sale. In addition, we assume that when some firms receive bad shocks and are forced to fire-sell assets, other firms receive good shocks and are therefore in a favorable position to buy the cheap, fire-sold assets. Firms in our model then consider strategically how their choices affect prices, both when they receive bad shocks and contribute to fire sales, and when they receive good shocks and benefit from fire sales.
We argue that the case of partial liquidation applies to firms that borrow to invest in real assets. Sometimes a firm will have unexpectedly low cash flows from its assets but nevertheless has to make a debt payment. In this case, the firm is forced to sell some of its assets to raise the necessary cash to pay its creditors. A firm with market power knows that when it receives a bad shock it will sell assets, and so, strategically, it would like to hold fewer assets so the price at which it can sell is higher. The firm also knows that when it receives a good shock it will buy assets, in which case it would like to have fewer funds available so that it can buy at a lower price—which occurs, again, by holding fewer assets. Whether the firm ends up as a buyer or a seller, investing less initially is beneficial in either case. How much investment is discouraged depends on the degree of individual risk as measured by the difference between a good and a bad productivity shock. If individual productivity risk is small, the strategic incentive to reduce investment is small and partially mitigates the inefficiently high investment under perfect competition. But sufficiently high productivity risk pushes investment below the efficient level, thus overcorrecting the original inefficiency.
The case of full liquidation is more reminiscent of a financial institution such as a bank that funds its assets with short-term debt and exposes itself to the risk of runs. In a classic bank run, where all creditors demand repayment of their debt at the same time, the bank is forced to liquidate all of its assets but is still unable to fully repay its debt. A bank with market power knows that, in order to keep the price high as a seller, it should hold fewer illiquid assets (since it will be forced to sell these assets) and more liquid assets. But in order to keep the price low as a buyer, it should hold fewer liquid assets (which it will use for future purchases) and more illiquid assets. Thus, the firm’s initial decision has to balance its divergent perspectives as a buyer and a seller. It turns out that, when the price is sufficiently low, the strategic incentive to invest more in illiquid assets and buy at cheap prices dominates. Such a sufficiently low price occurs if the occurrence of fire sales is sufficiently rare. In this case, investment is pushed above the efficient level, thus exacerbating the original inefficiency.
What Do Our Results Imply for Policy?
Our results highlight that policy interventions that aim to address fire-sale externalities have to be tailored to both the type of activity and the competitiveness of a given sector. Accordingly, the policy implications of our results differ for the real and financial sectors. For the real sector, where market power overcorrects the tendency toward inefficient credit booms, our results imply a need for stronger investment stimulus as the sector becomes more concentrated. In contrast, for the financial sector, where market power exacerbates the tendency to hold insufficient liquidity, our results imply a need for stronger liquidity regulation as the sector becomes more concentrated. Finally, our results speak to antitrust policy, highlighting additional welfare-relevant effects of market power. For example, in the debate on whether concentration enhances financial stability (Bordo, Redish, and Rockoff, 2015), our results show the importance of stringent liquidity regulations for achieving stability benefits from concentration.
Thomas Eisenbach is a senior economist in the Research and Statistics Group.
Gregory Phelan is an associate professor of economics at Williams College.
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.