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Taking regulation seriously: fire sales under solvency and liquidity constraints

Author

Listed:
  • Coen, Jamie

    () (London School of Economics)

  • Lepore, Caterina

    () (Bank of England)

  • Schaanning, Eric

    () (RiskLab, ETH ZÜrich and Norges Bank)

Abstract

We build a framework for modelling fire sales where banks face both liquidity and solvency constraints and choose which assets to sell in order to minimise liquidation losses. Banks constrained by the leverage ratio prefer to first sell assets that are liquid and held in small amounts, while banks constrained by the risk-weighted capital ratio and the liquidity coverage ratio need to trade off assets’ liquidity with their regulatory weights. We calibrate the model to the UK banking system, and find that banks’ optimal liquidation strategies translate into moderate fire-sale losses even for extremely large solvency shocks. By contrast, severe funding shocks can generate significant losses. Thus models focusing exclusively on solvency risk may significantly underestimate the extent of contagion via fire sales. Moreover, when studying combined funding and solvency shocks, we find complementarities between the two shocks’ effects that cannot be reproduced by focusing on either shock in isolation.

Suggested Citation

  • Coen, Jamie & Lepore, Caterina & Schaanning, Eric, 2019. "Taking regulation seriously: fire sales under solvency and liquidity constraints," Bank of England working papers 793, Bank of England.
  • Handle: RePEc:boe:boeewp:0793
    as

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    File URL: https://www.bankofengland.co.uk/-/media/boe/files/working-paper/2019/taking-regulation-seriously-fire-sales-under-solvency-and-liquidity-constraints.pdf
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    Banks; financial regulation; fire sales; stress testing; systemic risk;

    JEL classification:

    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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