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

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.