DP7147 A Theory of Slow-Moving Capital and Contagion

Author(s): Viral V. Acharya, Hyun Song Shin, Tanju Yorulmazer
Publication Date: January 2009
Keyword(s): arbitrage, crises, fire sales, illiquidity, spillover
JEL(s): D62, E58, G21, G28, G38
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=7147

Fire sales that occur during crises beg the question of why sufficient outside capital does not move in quickly to take advantage of fire sales, or in other words, why outside capital is so slow-moving. We propose an answer to this puzzle in the context of an equilibrium model of capital allocation. Keeping capital in liquid form in anticipation of possible fire sales entails costs in terms of foregone profitable investments. Set against this, those same profitable investments are rendered illiquid in future due to agency problems embedded with expertise. We show that a robust consequence of this trade-off between making investments today and waiting for arbitrage opportunities in future is the combination of occasional fire sales and limited stand-by capital that moves in only if fire-sale discounts are sufficiently deep. An extension of our model to several types of investments gives rise to a novel channel for contagion where sufficiently adverse shocks to one type can induce fire sales in other types that are fundamentally unrelated, provided arbitrage activity in these investments is sourced from a common pool of capital.