Discussion Paper

On Fire-Sale Externalities, TARP Was Close to Optimal

Abstract: Imagine that many large and levered banks suffer heavy losses and must quickly sell assets to reduce their leverage. We expect the market price of the assets sold to decline, at least temporarily. As a result, any other financial institutions that happen to hold the same assets will experience balance sheet losses through no fault of their own —a negative fire-sale externality. In this post, we show that the vulnerability to fire-sale externalities was high during the crisis and that the capital injections of the government’s Troubled Asset Relief Program (TARP) helped reduce it considerably. In fact, we argue that given the total amount injected, TARP was close to optimal.

Keywords: Systemic risk; Fire sales; TARP;

JEL Classification: G1; G2;

Bibliographic Information

Provider: Federal Reserve Bank of New York

Part of Series: Liberty Street Economics

Publication Date: 2014-04-15

Number: 20140415

Note: This post is the third in a series of six Liberty Street Economics posts on liquidity issues.