Taking Regulation Seriously: Fire Sales Under Solvency and Liquidity Constraints

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.