The Effects of Leverage Requirements and Fire Sales on Financial Contagion via Asset Liquidation Strategies in Financial Networks

TL;DR

This paper models how leverage requirements and fire sales influence financial contagion through asset liquidation strategies in networks, extending previous models to multiple assets and analyzing systemic risk.

Contribution

It introduces a framework for multiple illiquid assets with leverage constraints, proving equilibrium existence and calibrating models to real bank data.

Findings

Leverage requirements significantly impact systemic risk.

Equilibrium liquidation strategies exist under certain conditions.

Calibrated models reveal leverage's role in contagion risk.

Abstract

This paper provides a framework for modeling the financial system with multiple illiquid assets when liquidation of illiquid assets is caused by failure to meet a leverage requirement. This extends the network model of Cifuentes, Shin & Ferrucci (2005) which incorporates a single asset with fire sales and capital adequacy ratio. This also extends the network model of Feinstein (2015) which incorporates multiple illiquid assets with fire sales and no leverage ratios. We prove existence of equilibrium clearing payments and liquidation prices for a known liquidation strategy when leverage requirements are required. We also prove sufficient conditions for the existence of an equilibrium liquidation strategy with corresponding clearing payments and liquidation prices. Finally we calibrate network models to asset and liability data for 50 banks in the United States from 2007-2014 in order to draw conclusions on systemic risk as a function of leverage requirements.