Fire Sales and Ex Ante Valuation of Systemic Risk: A Financial Equilibrium Networks Approach

The ability of financial regulators to safeguard the financial system depends on how accurately they assess the risks on the balance sheets of banks. Banks are interconnected through a complex web of financial obligations and during periods of crises the valuation of their assets depends on the state of the entire system. Small changes in the structure of the system can have a huge impact on risk assessment evaluations.

Pub. Date
28 November, 2022
Pub. Type

We introduce endogenous fire sales into a simple network model. For any given initial distribution of shocks across the network, we develop a clearing algorithm to solve for the financial equilibrium. We then utilise the results to perform ex ante risk assessment and derive risk premia for every balance sheet item where liabilities are differentiated according to priority rights. We find that risk premia reflect both idiosyncratic risk and risk of contagion (network risk). Moreover, we show that network risk magnifies the gap between the risk premia of equity and debt. We also perform comparative statics, showing that changes to the distribution of shocks and network structure can have substantial effects on the level of systemic losses.

See also "Distressed Banks, Distorted Decisions?" (NIESR Discussion Paper 503)