Fire Sales and Liquidity Requirements

Last updated: December 2024

We study liquidity requirements in a framework with fire sales. The framework nests three common pricing mechanisms—cash-in-the-market, second-best-use, and adverse selection—and can produce the same observables under different pricing mechanisms. We identify three forces that shape the optimal policy. Absent risk-sharing considerations, the equilibrium is efficient with cash-in-the-market pricing; a liquidity requirement is optimal with second-best-use pricing; and a liquidity ceiling (i.e., a cap on liquid assets) is optimal with adverse selection. Accounting for risk-sharing considerations, we find the optimal level of liquidity remains higher with second-best-use pricing relative to cash-in-the-market pricing, and a liquidity ceiling remains optimal with adverse selection.