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E-MailA central difficulty during banking crises is one of finding ready buyers of distressed assets. If a bank needs to restructure its balance sheet during a crisis or be sold as a going concern, the potential buyers are generally other banks, but they may have also been severely affected and thus be financially constrained and unable to purchase the bank or its assets. This leads to especially severe problems in a banking crisis given the relative opacity of bank balance sheets and the high sensitivity of banking assets to macroeconomic shocks. Surviving banks with enough liquidity during adverse states of the world stand to make windfall profits from purchasing assets at fire-sale prices. Even if crises arrive infrequently, the potential gains from acquisitions at fire sales could be large. This gives banks incentives to hold liquid assets so that in the event that they survive a crisis, they will have resources to take advantage of fire sales. In our recent working paper Crisis Resolution and Bank Liquidity, we present a model of banks’ choice of ex-ante liquidity that is driven by these strategic considerations.
We examine the portfolio choice of banks maximizing their profits in the presence of fire sales that are endogenously derived in an equilibrium setup of the banking industry. When risky assets have limited pledgeability and banks have relative expertise in employing risky assets, the market for these assets clears only at fire-sale prices following a large number of bank failures. The gains from acquiring assets at fire-sale prices make it attractive for banks to hold liquid assets. We show that the resulting choice of bank liquidity is counter-cyclical, inefficiently low during economic booms but excessively high during crises, and present and discuss evidence consistent with these predictions. Since inefficient users may enter asset markets when prices fall sufficiently, interventions to resolve banking crises may be desirable ex post. However, policies aimed at resolving crises affect ex-ante bank liquidity in subtle ways: while liquidity support to failed banks or unconditional support to surviving banks in acquiring failed banks give banks incentives to hold less liquidity, support to surviving banks that is conditional on their liquid asset holdings creates incentives for banks to hold more liquidity.
The global financial crisis of 2007-2009 offers a live laboratory for many of the themes explored in this paper. In the process of resolving weak and failing banks, banks with apparently stronger balance sheets have been selected as the potential acquirers of weak banks. In the United States, the role of J.P. Morgan Chase in acquiring Bear Stearns in March 2008 first captured headlines. But the theme played out again with the takeover of Merrill Lynch by Bank of America in September of 2008 and of Wachovia by Wells Fargo in October 2008. In these instances, stronger banks have placed themselves in the position to acquire rivals that have been weakened by the crisis. As Bank of America’s troubled takeover of Merrill Lynch has shown, such acquisitions are not without risk. However, crises do seem to present a unique opportunity for banks to boost their relative standing in the industry.
The full paper is available for download here.
