Upcoming working paper: Leverage constraints can create systemic risk b/c institutions have to sell when prices drop. We show: Equilibrium structure & convergence depends on the shape of price impact. 🧵
Model: Institutions each hold a portfolio of different assets. The asset × institution relation forms a network of overlapping portfolios. Institutions strategically sell their assets, maximizing equity and satisfying a leverage constraint. Equilibria are static (no timing).
Central phenomenon: Sales by one institution trigger price depreciations, violating other institutions' leverage constraints, who then need to sell in turn. This leads to a cascade. Low prices may further incentivize runs on an asset.
Result 1: Things are rel. stable if price impact is convex or if institutions need to fully absorb their implementation shortfall. Then there is a lattice of equilibria and the social optimum is also a strong equilibrium; iterative processes converge there well.
Result 2: Not so much otherwise (e.g. concave price impact and partial implementation shortfall). Then we might not even have an equilibrium. It also matters how much insts. can re-organize their portfolio responding to shocks.
Joint work with my colleagues from @goetheuni and @HPI_DE.
Related work: E.g.: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2541114, https://arxiv.org/abs/1407.5305
Research Question: How does the microstructure of the market (specifically, price impact) affect the structure & convergence to equilibria in the fire sales game?