Taking Regulation Seriously: Fire Sales Under Solvency and Liquidity Constraints

53 Pages Posted: 26 Apr 2019

See all articles by Jamie Coen

Jamie Coen

Bank of England

Caterina Lepore

International Monetary Fund (IMF)

Eric Schaanning

Norges Bank; European Systemic Risk Board - EUROPEAN SYSTEMIC RISK BOARD

Date Written: April 26, 2019

Abstract

We build a framework for modelling fire sales where banks face both liquidity and solvency constraints and choose which assets to sell in order to minimise liquidation losses. Banks constrained by the leverage ratio prefer to first sell assets that are liquid and held in small amounts, while banks constrained by the risk-weighted capital ratio and the liquidity coverage ratio need to trade off assets’ liquidity with their regulatory weights. We calibrate the model to the UK banking system, and find that banks’ optimal liquidation strategies translate into moderate fire-sale losses even for extremely large solvency shocks. By contrast, severe funding shocks can generate significant losses. Thus models focusing exclusively on solvency risk may significantly underestimate the extent of contagion via fire sales. Moreover, when studying combined funding and solvency shocks, we find complementarities between the two shocks’ effects that cannot be reproduced by focusing on either shock in isolation.

Keywords: Banks, financial regulation, fire sales, stress testing, systemic risk

JEL Classification: G18, G21

Suggested Citation

Coen, Jamie and Lepore, Caterina and Schaanning, Eric and Schaanning, Eric, Taking Regulation Seriously: Fire Sales Under Solvency and Liquidity Constraints (April 26, 2019). Bank of England Working Paper No. 793, Available at SSRN: https://ssrn.com/abstract=3378586 or http://dx.doi.org/10.2139/ssrn.3378586

Jamie Coen (Contact Author)

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

Caterina Lepore

International Monetary Fund (IMF) ( email )

Kuwait

Eric Schaanning

Norges Bank ( email )

P.O. Box 1179
Oslo, N-0107
Norway

European Systemic Risk Board - EUROPEAN SYSTEMIC RISK BOARD ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

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