Playing with fire: banks’ distressed sales under solvency and liquidity constraints

Caterina Lepore and Jamie Coen

Many commentators on the global financial crisis identified ‘fire sales’ as one of the key mechanisms by which shocks to banks were amplified and transmitted across the wider financial system. When firms in distress sell assets held by other institutions at discounted prices, losses can spread through the financial system as prices fall, amplifying the initial stress. In a working paper published last year, we explored this mechanism by presenting a new model of fire sales. In doing so, we answer the following questions: Which types of financial shocks combine to produce fire sales? How can banks optimally liquidate their portfolios when forced to do so? How big a risk are bank fire sales?

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The decline of solvency contagion risk

Marco Bardoscia, Paolo Barucca, Adam Brinley Codd and John Hill

The failure of Lehman Brothers on 15 September 2008 sent shockwaves around the world.  But the losses at Lehman Brothers were only the start of the problem.  The price of their bonds halved, almost overnight.  Other institutions that held Lehman’s debt faced huge losses, and markets feared that those losses could trigger further failures. The good news is that our latest research suggests that risks within the UK banking system from one such contagion channel, “solvency contagion”, have declined sharply since 2008. We have developed a new model which quantifies risk from this channel, and helps us understand why it has fallen.  Regulators are using the model to monitor this particular source of risk as part of the Bank’s annual concurrent stress test exercise.

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Bank liquidity requirements: How to get more bang for your buck

Iñaki Aldasoro, Ester Faia, Gerardo Ferrara, Sam Langfield, Zijun Liu and Tomohiro Ota.

We make the case for a macroprudential approach to liquidity requirements in the cross-section of banks. Currently, the liquidity coverage requirement is applied uniformly across banks. This microprudential approach overlooks externalities: owing to their size, complexity and position in the interbank funding network, some banks can cause inordinate damage to the rest of the banking system. When externalities are taken into account, we show that these systemically important banks should be subject to more stringent liquidity requirements. This cross-sectional macroprudential approach promises “more bang for the buck”: systemic risk can be reduced without increasing the stringency of liquidity requirements for the banking system as a whole.

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