How does market power affect fire selling externalities?

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An important role of capital and liquidity regulations for financial institutions is to address the inefficiencies associated with ‘fire sale externalities’, such as the tendency of institutions to raise and hold illiquid assets to the extent that their Collective actions increase financial vulnerabilities. However, theoretical models that study these externalities generally assume perfect competition between financial institutions, despite a high (and growing) concentration of the financial sector. In this article based on our next articleinstead, we examine how the effects of clearance externalities change when financial institutions have market power.

What do standard models have to say about fire selling externalities?

An externality arises when the behavior of a business (or a consumer) affects others but the business ignores these effects when considering its own actions. Discount selling externalities occur when the sales of one company’s assets affect their prices, with potentially damaging consequences for others. For example, a bank creates clearance externalities when it uses leverage to make illiquid loans, but ignores the fact that, if it were to sell these loans to repay its creditors, the sales would lead to lower prices, affecting other institutions with similar assets. .

Standard models that assume perfectly competitive firms often show that transfer-to-sell externalities lead to inefficiently high levels of leverage (e.g. Lorenzoni, 2008) and illiquid assets (for example, Allen and Gale, 2004) because companies do not internalize how their investment decisions affect discount selling prices today at a later date, when they may have to sell. In reality, however, companies do not operate in perfectly competitive environments, raising the possibility that they internalize price impacts in asset markets. In fact, industry concentration has increased dramatically over the past few decades, both in the real sector and in the financial sector. In the real sector, increased concentration manifests itself in reduced competition, increased margins, and lower entry and exit rates (Gutiérrez and Philippon, 2018). In the financial sector, the share of total bank assets held by the five largest banks is 47% in the United States and between 71% and 84% in the United Kingdom, France, Germany, Italy and Canada (Corbae and Levine, 2018). Over 90 percent of the notional amount of derivative contracts is accounted for by five banks (OCC, 2018).

In standard models, the externality of discount sales would be reduced if firms internalized their price effects: firms would invest in less capital (i.e. borrow less) or invest in fewer illiquid assets. (i.e. holding more than the asset prices would fall less when forced to sell. our next article, we show that the intuition of market power reducing the ineffectiveness of clearance sale externalities is not robust. Instead of being mitigated, inefficiency can either be overcorrected or even exacerbated, so that industry concentration could worsen fire sales.

How can market power have perverse effects on fire sales?

Whether market power mitigates or exacerbates unwanted sales depends on the mechanism that causes them and whether it forces firms to liquidate some or all of their assets. In a common theoretical framework, flash sales occur when business investments do not return as much as expected, forcing companies to sell some of their illiquid assets to pay off debt. In another common context, flash sales occur when companies are faced with leaks from their creditors, forcing them to sell all of their illiquid assets.

Compared to standard models, we assume imperfect “Cournot” competition where firms take into account their effects on asset prices in a future discount sale. Further, we assume that when some firms receive bad shocks and are forced to sell assets, other firms receive good shocks and therefore are in a favorable position to buy the cheap and sold assets. Firms in our model then strategically examine how their choices affect prices, both when they receive bad shocks and contribute to clearance sales, and when they receive good shocks and benefit from clearance sales.

We argue that the partial liquidation case applies to companies that borrow to invest in real assets. Sometimes a business will have surprisingly low cash flow from its assets, but still have to repay its debt. In this case, the company is forced to sell part of its assets to raise the cash needed to pay its creditors. A company with market power knows that when it receives a bad shock it will sell assets, and therefore, strategically, it would like to hold fewer assets so that the price at which it can sell is higher. The company also knows that when it receives a good shock it will buy assets, in which case it would like to have less funds available so it could buy at a lower price – which happens, again, by holding less money. active. Whether the business ends up being a buyer or a seller, investing less up front is beneficial in both cases. The degree of discouraged investment depends on the degree of individual risk measured by the difference between a good and a bad productivity shock. If the risk of individual productivity is low, the strategic incentive to reduce investment is weak and partly mitigates too high investment in a situation of perfect competition. But a sufficiently high productivity risk pushes the investment below the efficient level, thus overcorrecting the initial inefficiency.

The case of total liquidation is more reminiscent of a financial institution such as a bank that finances its assets with short-term debts and is exposed to run risk. In a classic bank run, where all the creditors demand the repayment of their debt at the same time, the bank is forced to liquidate all its assets but is still not able to fully repay its debt. A bank with market power knows that in order to maintain a high price as a seller it must hold less illiquid assets (since it will be forced to sell those assets) and more liquid assets. But in order to keep the price low as a buyer, he would have to hold less liquid assets (which he will use for future purchases) and more illiquid assets. Thus, the company’s initial decision must balance its divergent perspectives as a buyer and a seller. As it turns out, when the price is low enough, the strategic incentive to invest more in illiquid assets and buy at low prices dominates. Such a sufficiently low price occurs if the occurrence of clearance sales is sufficiently rare. In this case, the investment is pushed above the efficient level, thus exacerbating the initial inefficiency.

What do our results imply for policy?

Our results underline that policy interventions aimed at combating fire sales externalities must be adapted both to the type of activity and to the competitiveness of a given sector. Therefore, the policy implications of our results differ for the real and financial sectors. For the real sector, where market power overcorrects the tendency for inefficient credit booms, our results imply the need for a stronger incentive to invest as the sector becomes more concentrated. In contrast, for the financial sector, where market power exacerbates the tendency to hold insufficient liquidity, our results imply the need for tighter liquidity regulation as the sector becomes more concentrated. Finally, our results concern antitrust policy, highlighting the additional effects of market power on welfare. For example, in the debate on whether concentration improves financial stability (Bordo, Redish and Rockoff, 2015), our results show the importance of tight liquidity regulations to achieve stability benefits through concentration.

Thomas eisenbach

Gregory Phelan is Associate Professor of Economics at Williams College.


Disclaimer
The opinions expressed in this article are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.


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