Price mediated contagion through capital ratio requirements with VWAP liquidation prices

Tathagata Banerjee, Zachary Feinstein

Research output: Contribution to journalArticlepeer-review

11 Scopus citations

Abstract

We develop a framework for price-mediated contagion in financial systems where banks are forced to liquidate assets to satisfy a risk-weight based capital adequacy requirement. In constructing this modeling framework, we introduce a two-tier pricing structure: the volume weighted average price that is obtained by any bank liquidating assets and the terminal mark-to-market price used to account for all assets held at the end of the clearing process. We consider the case of multiple illiquid assets and develop conditions for the existence and uniqueness of clearing prices. We provide a closed-form representation for the sensitivity of these clearing prices to the system parameters, and use this result to quantify: (1) the cost of regulation, in stress scenarios, faced by the system as a whole and the individual banks, and (2) the value of providing bailouts to consider when such notions are financially advisable. Numerical case studies are provided to study the application of this model to data.

Original languageEnglish
Pages (from-to)1147-1160
Number of pages14
JournalEuropean Journal of Operational Research
Volume295
Issue number3
DOIs
StatePublished - 16 Dec 2021

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