Fire sales and the financial accelerator

During financial turmoil, increases in risk lead to higher default, foreclosure, and fire sales. This paper introduces a costly liquidation process for foreclosed collateral and pro-cyclical recovery rates in a dynamic stochastic general equilibrium model of the financial accelerator. Links between endogenous recovery rates, risk premia, and default risk generate a liquidity spiral, magnifying financial accelerator effects. We illustrate how collateral liquidation and monetary policy alter the real impact of financial shocks operating through macro-financial linkages; and the way a government subsidy on collateral liquidity and required liquidity buffers can help dampen the liquidity spiral by shoring up recovery rates. ► Collateral market illiquidity can explain counter-cyclical recovery rates. ► Counter-cyclical recovery rates vary negatively with default rates. ► Links between recovery rates and risk premia exacerbate financial shock effects. ► A collateral liquidity subsidy and liquidity buffers can shore up recovery rates.