Bank’s strategic interaction, adverse price dynamics and systemic liquidity risk

Abstract

When a widespread funding shock hits the banking system, banks may engage in strategic behaviour to deal with funding shortages by a pre-emptive disposal of assets. Alternatively, they may adopt a more cautious strategy to mitigate price reactions, thereby distributing the assets sales into smaller portions over time. We model banks’ optimal behaviour using standard optimisation techniques and show that an equilibrium always exits in a stylised setting. A numerical analysis to approximate the equilibrium supplements the theoretical part. The implementation delivers two liquidity measures for the German banking system: the Systemic Liquidity Buffer and the Systemic Liquidity Shortfall. These measures are more informative about systemic liquidity risk than regulatory liquidity measures, such as the LCR, because they model adverse, nonlinear price dynamics in a more realistic way. Our approach is applied to different stress scenarios.