Price mediated contagion through capital ratio requirements with VWAP liquidation prices

TL;DR

This paper presents a framework for understanding how price-mediated contagion occurs in financial systems due to capital requirement-induced asset liquidations, incorporating a two-tier pricing structure and analyzing systemic risks and bailout implications.

Contribution

It introduces a novel two-tier pricing model for asset liquidation and provides conditions for clearing prices, along with sensitivity analysis and practical numerical case studies.

Findings

Quantifies systemic costs of regulation in stress scenarios

Analyzes the impact of bailouts on financial stability

Provides closed-form sensitivity of prices to system parameters

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.