Interbank Asset-Liability Networks with Fire Sale Management
Raising liquidity when funding is stressed creates pressure on the financial market. Liquidating large quantities of assets depresses their prices and may amplify funding shocks. How do banks weathering a funding crisis contribute to contagion risk?
We propose a model to study the transmission of distress in a banking system that has been hit by a funding shock. The model captures (1) the indirect effects of price impacts due to the optimal reinvestment of banks’ asset mixture and (2) the direct network effects if banks cannot fully pay back their interbank exposures.
We demonstrate how banks liquidate assets in equilibrium and at what price, and we examine the role of regulators in stabilizing prices in a funding crisis. Our empirical results, based on the Canadian supervisory data, show that even very large funding shocks are unlikely to trigger a cascade of defaults. However, losses incurred on liquidated assets in fire sales may be substantial. Nevertheless, banks are less likely to overreact or sell more than strictly necessary when they take other banks' actions into account.