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IAI Actuarial Core Principles · Business Economics · Role, structure and stability of the financial system

During a sharp fall in asset prices, many leveraged institutions sell assets to meet margin calls and capital requirements, which pushes prices down further and forces more selling. Which description fits this process, and what is its main consequence?

This is a fire-sale spiral: forced asset sales depress prices, which weakens other holders' balance sheets and triggers more sales. The feedback loop amplifies the initial shock and spreads it across institutions holding similar assets, increasing systemic instability.

  1. AMoral hazard, which encourages banks to take more risk because deposits are insured
  2. BAdverse selection, which leads lenders to attract only the riskiest borrowers
  3. CA fire-sale spiral, in which falling prices weaken balance sheets and amplify the original shock across institutionsCorrect
  4. DCrowding out, in which government borrowing raises interest rates and reduces private investment
  5. The paradox of thrift, in which higher saving reduces aggregate demand

Explanation

Forced sales by leveraged holders depress prices, which reduces the value of similar assets held by others, tightening their constraints and prompting further sales. This feedback amplifies shocks and spreads them through common exposures. Moral hazard and adverse selection concern incentives and information, crowding out concerns fiscal policy, and the paradox of thrift concerns saving and demand.

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