DP16793 The Financial Origins of Non-Fundamental Risk

Author(s): Sushant Acharya, Keshav Dogra, Sanjay R. Singh
Publication Date: December 2021
Keyword(s): fire sales, liquidity, safe assets, self-fulfilling asset market crashes
JEL(s): D52, D84, E62, G10, G12
Programme Areas: Financial Economics, Monetary Economics and Fluctuations, Macroeconomics and Growth
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=16793

We formalize the idea that the financial sector can be a source of non-fundamental risk. Households' desire to hedge against price volatility can generate price volatility in equilibrium, even absent fundamental risk. Fearing that asset prices may fall, risk-averse households demand safe assets from leveraged intermediaries, whose issuance of safe assets exposes the economy to self-fulfilling fire sales. Policy can eliminate non-fundamental risk by (i) increasing the supply of publicly backed safe assets, through issuing government debt or bailing out intermediaries, or (ii) reducing the demand for safe assets, through social insurance or by acting as a market maker of last resort.