Strategic Fire-Sales and Price-Mediated Contagion in the Banking System

49 Pages Posted: 13 Sep 2017 Last revised: 25 Nov 2018

See all articles by Yann Braouezec

Yann Braouezec

IESEG School of Management, LEM CNRS, UMR 9221

Lakshithe Wagalath

IESEG School of Management

Date Written: November 23, 2018

Abstract

We consider a price-mediated contagion framework in which each bank, after an exogenous shock, may have to sell assets in order to comply with regulatory constraints. Interaction between banks takes place only through price impact. We characterize the equilibrium of the strategic deleveraging problem and we calibrate our model to publicly-available data, the US banks that were part of the 2015 regulatory stress-tests. We then consider a more sophisticated model in which each bank is exposed to two risky assets (marketable and not marketable) and is only able to sell the marketable asset. We calibrate our model using the six banks with significant trading operations and we show that, depending on the price impact, the contagion of failures may be significant. Our results may be used to refine current stress testing frameworks by incorporating potential contagion mechanisms between banks.

Keywords: Fire sales, price-mediated contagion, Nash equilibrium with strategic complementarities, CCAR 2015, macro-prudential stress-tests

JEL Classification: G28

Suggested Citation

Braouezec, Yann and Wagalath, Lakshithe, Strategic Fire-Sales and Price-Mediated Contagion in the Banking System (November 23, 2018). European Journal of Operations Research, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3033785 or http://dx.doi.org/10.2139/ssrn.3033785

Yann Braouezec (Contact Author)

IESEG School of Management, LEM CNRS, UMR 9221 ( email )

1, parvis de la Défense
Paris-La Défense cedex, 92044
France

Lakshithe Wagalath

IESEG School of Management ( email )

1 Parvis de la Défense
Paris, 92044
France

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