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Preventing fire sales and market freezes is about putting liquidity in the right hands

Why do banks’ liquidity problems lead to fire sales of assets, and sometimes also a market freeze? Swedish House of Finance’s Jungsuk Han has explored the topic in a recent paper, coming up with some interesting implications for policy makers.

Jungsuk Han, assistant professor at the Stockholm School of Economics, focuses his research on mispricing in the financial markets. In a recent paper published in the Journal of Finance, Jungsuk Han and his co-author James Dow explore the mechanism that leads to extreme under evaluation of assets, during so called fire sales. The paper concerns situations such as the financial crisis of 2008, exploring why the volumes of the financial markets dried out and why fire sales of assets happened.

“During the 2008 crisis, the financial institutions ran out of money to buy assets. As a result, the prices went down. But what about other investors, non-specialist investors such as pension funds, or wealthy investors such as Warren Buffett? They could easily have gone into the market, bought at a low price and earned a lot of money. Why didn’t they?”, Jungsuk Han asks.

 

Why non-specialist investors leave
An important mechanism that Jungsuk Han has explored is the consequence of so called specialist investor leaving the market. Specialists investors are well informed investors, such as financial institutions, that have knowledge of the quality of assets on the market. Their knowledge gives them an important price setting function in the market. When they are active in a market, non-specialist investors – such as individuals, or wealth investors – can buy assets knowing that the price is right and without worrying about quality, Jungsuk Han explains.

“So the specialist investors keep the markets functioning well”, Jungsuk Han says, and uses an allegory to further illustrate the mechanism:

“When I travelled to Venice, I saw a long line of people queueing to eat at McDonalds. Food in Italy is fantastic, so why is this? The reason is that in a local area, restaurants can’t cheat on the price – if the price isn’t fair they will go out of business. But in an area dominated by tourists, this market pricing mechanism does not work. Most guests will never return anyway and the restaurants can overcharge without going out of business.”

So without locals to control prices, clients cannot trust that the prices are fair. Knowing this, tourists risk purchasing in a market of lemons: many restaurants may be over priced.
“So the rational choice becomes to eat at McDonalds, where you know you will not be overcharged”, says Jungsuk Han.

 

Double whammy
The same phenomenon occurs during a financial crisis: when no buyers remain that know the quality of assets in the market, there is no function for setting correct prices. And then, the non-specialized investors opt out, as the risk is too high that they will be buying bad assets.

“So when specialist investors leave, non-specialist investors become unwilling to provide liquidity. In worst case, you get a double whammy – a fire sale when good assets are selling at extreme under evaluation, and then a market freeze when volumes drop low”, says Jungsuk Han.
“Our paper is about financial markets, but this phenomenon can occur anywhere”, he explains.

 

What are the consequences of your findings?
“It has implications about interpreting the previous financial crises. There was liquidity dry out in multiple security markets, and there was a market freeze where there was not enough volume. According to our theory, it happened because specialist investors lacked capital. Even though there was enough capital, it would not come to the market because the specialist investors were not in the market. And because the good assets would then not come to the market, the trading volume would go away. Double whammy happened and the market almost collapsed. And it happened even in the face of large capital out there in the economy. “

 

What can be done to prevent this in the future?
“Our work has some policy implications. There are many ways or relieving this kind of crisis. One is buying up assets in the market. But what we are saying is that this may not work well if government money is used to buy assets regardless of quality. That will reduce some shocks, but not create the multiplying effect that is needed.”

What is needed is instead specialist investors returning to steer the pricing of the market.

“Our finding is that providing more liquidity to the specialists might work better than to just buy assets. The specialist know what assets are good and bad, and will restore confidence in the pricing system, which will return liquidity to the markets. Of course there are other implications to think about, such as discouraging moral hazard of financial institutions. But disregarding that, you can think of the problem this way”, states Jungsuk Han.

 

Want to read more?

Read the paper “The Paradox of Financial Fire Sales: The Role of Arbitrage Capital” by Jungsuk Han and James Dow.

Furthermore, Jungsuk Han and James Dow have previously written “Contractual incompleteness, limited liability and asset price bubbles”, Journal of Financial Economics 116(2) .

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