Financial Stability with Fire Sale Externalities

Abstract Do policies mitigating fire sale externalities improve financial stability? We study this question in a model of financial intermediation where banks are subject to self‐fulfilling bank runs and may sell long‐term assets subject to cash‐in‐the‐market pricing. Without regulations, banks hold more long‐term assets than socially optimal, causing inefficiently large fire sales in crises. Policymakers may regulate to mitigate this externality, but lack commitment. The optimal policy depends on how regulation affects the probability of self‐fulfilling runs, and we offer a robust control theory of this relationship. Ignoring this effect could inadvertently increase fragility and lower welfare. Internalizing it robustly increases welfare.