How is the likelihood of fire sales affected by the interaction of multiple bank regulations?

Abstract:

We present a model that describes how different types of bank regulation can interact to affect the likelihood of fire sales in a crisis. We focus on a situation in which banks experience a shock to asset values, face binding capital requirements, and therefore must recapitalize. We assume that banks act in the interest of their shareholders, which leads to the optimal recapitalization being influenced by risk-shifting motives. We have three main results. First, the design of the capital requirement strongly affects whether fire sales of risky assets can be an equilibrium outcome. For example, with a simple leverage requirement, banks choose to sell relatively safe assets in response to a shock. With a risk-weighted capital requirement, high risk weights can actually push banks toward fire sales of risky assets. Second, the interaction between capital and liquidity requirements can also make fire sales more likely. Third, fire sales of risky assets are not necessarily prevented by mandating that banks issue equity when undercapitalized. Collectively, our findings suggest that if a goal of macroprudential regulation is to prevent banks from engaging in fire sales of risky assets, the ex-post incentives created by high risk weights and the interaction between capital and liquidity requirements are important considerations. 

Last updated on 10/25/2015