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Stressed but not Helpless: Strategic Behaviour of Banks Under Adverse Market Conditions

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  • Grzegorz Halaj
  • Sofia Priazhkina

Abstract

We model bank management actions in severe stress test conditions using a game-theoretical framework. Banks update their balance sheets to strategically maximize risk-adjusted returns to shareholders given three regulatory constraints and feedback effects related to fire sales, interactions of loan supply and demand, and deteriorating funding conditions. The framework allows us to study the role of strategic behaviors in amplifying or mitigating adverse macrofinancial shocks in a banking system and the role of macroprudential policies in the mitigation of systemic risk. In a macro-consistent stress testing application, we show that a trade-off can arise between banking stability (solvency) and macroeconomic stability (lending) and test whether the release of a countercyclical capital buffer can reduce systemic risk.

Suggested Citation

  • Grzegorz Halaj & Sofia Priazhkina, 2021. "Stressed but not Helpless: Strategic Behaviour of Banks Under Adverse Market Conditions," Staff Working Papers 21-35, Bank of Canada.
    • Handle: RePEc:bca:bocawp:21-35
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    References listed on IDEAS

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    2. Busch, Ramona & Drescher, Christian & Memmel, Christoph, 2017. "Bank stress testing under different balance sheet assumptions," Discussion Papers 07/2017, Deutsche Bundesbank.
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    7. Grzegorz Hałaj, 2016. "Dynamic Balance Sheet Model With Liquidity Risk," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 19(07), pages 1-37, November.
    8. Mr. Troy D Matheson & Mr. Ivo Krznar, 2017. "Towards Macroprudential Stress Testing: Incorporating Macro-Feedback Effects," IMF Working Papers 2017/149, International Monetary Fund.
    9. Charles Gaa & Xuezhi Liu & Cameron MacDonald & Xiangjin Shen, 2019. "Assessing the Resilience of the Canadian Banking System," Staff Analytical Notes 2019-16, Bank of Canada.
    10. Manuel Adelino & Miguel A. Ferreira, 2016. "Bank Ratings and Lending Supply: Evidence from Sovereign Downgrades," Review of Financial Studies, Society for Financial Studies, vol. 29(7), pages 1709-1746.
    11. M. I. Kusy & W. T. Ziemba, 1986. "A Bank Asset and Liability Management Model," Operations Research, INFORMS, vol. 34(3), pages 356-376, June.
    12. Hałaj, Grzegorz, 2013. "Optimal asset structure of a bank - bank reactions to stressful market conditions," Working Paper Series 1533, European Central Bank.
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    Cited by:

    1. Vladimir Skavysh & Sofia Priazhkina & Diego Guala & Thomas Bromley, 2022. "Quantum Monte Carlo for Economics: Stress Testing and Macroeconomic Deep Learning," Staff Working Papers 22-29, Bank of Canada.

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    More about this item

    Keywords

    Central bank research; Economic models; Financial institutions; Financial stability; Financial system regulation and policies;
    All these keywords.

    JEL classification:

    • C72 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Noncooperative Games
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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