Staff Working Paper No. 1,020
By Harkeerit Kalsi, Nicholas Vause and Nora Wegner
Motivated by the March 2020 ‘dash for cash’, we build a model in which a potential liquidity shock to bond funds can prompt a self-fulfilling fire sale in the presence of a dealer with limited trading capacity. Following the global games literature, we derive the probability of a self-fulfilling fire sale. Introducing a central bank market backstop policy, we show that if the central bank can credibly commit to (i) set the size of its potential asset purchases high enough and (ii) its price discount low enough, then it can eliminate self-fulfilling fire sales without having to purchase any bonds. If the central bank acts less aggressively, it can still reduce the probability of a self-fulfilling fire sale. However, in response to the policy, funds choose to hold more bonds, which increases the probability of a self-fulfilling fire sale and reduces the effectiveness of the market backstop.