Fire sales, pecuniary externality and inefficient banking

[Link to the latest version] To investigate the social cost of fire sales, I build a banking model a ̀ la Diamond and Dybvig in which an aggregate liquidity shock hits consumers preferences before asset returns are realized. Banks can sell assets to mutual funds when this shock is too high to pay the depositors hit by the shock. The wealth of the buyers of assets, the mutual funds, results from a portfolio allocation by households between bank deposits and mutual funds shares. I identify one combination of imperfections that gives rise to a pecuniary externality implying a welfare loss: an asymmetry of information between banks and depositors regarding depositors ’ liquidity needs on top of an incomplete market feature. Distortions lay both in the banks ’ choice, between assets and reserves, and in the households ’ choice, between bank deposits and mutual funds shares. High liquidity shock triggers bank default for low level of funds wealth. The price then falls below the fundamental value at a cash-in-the-market value. As banks do not realize that such a fire sale situation might occur, they do not optimally insure depositors against the idiosyncratic liquidity risk. It implies both an ex ante and an ex post welfare loss. Whereas efficiency would require banks to keep a liquidity buffer, they do not keep enough reserves and invest too much in assets. Imposing liquidity ratios allows to get closer to efficiency but not to reach the constrained efficient allocation. Indeed, liquidity ratios cannot help alleviate the distortion laying in the households’ choice. ∗PhD candidate in Paris 1 Sorbonne and Paris School of Economic