Liquidity and Solvency Risks in Financial Networks

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Abstract

Financial stress testing is a common method to evaluate the resilience and robustness of financial institutions to adverse scenarios. While prior research has mainly focused on individual firms, few have explored the systemic stability of the entire financial network and the contagion of defaulted bonds. In this work, we build on the literature for single firms to develop a joint stress-testing framework for financial networks, in which firms can choose different strategies to mitigate both liquidity and solvency risks. Using agent-based simulations and empirical game-theoretic analysis, we assess different strategic hedging portfolios and identify equilibrium conditions. We further examine the default probability under these conditions, and show that the central bank can effectively reduce the liquidity default probability of the banks in the system by appropriately setting interest rates. Finally, we analyze the impact of different strategies on the recovery rate (i.e., share of the liabilities that can be paid) of each bank, and find that this is higher when the banks choose an identical strategy.

Original languageEnglish
Title of host publicationICAIF 2023 - 4th ACM International Conference on AI in Finance
PublisherACM
Pages210-218
Number of pages9
ISBN (Electronic)9798400702402
ISBN (Print)9798400702402
DOIs
Publication statusPublished - 27 Nov 2023

Publication series

NameICAIF 2023 - 4th ACM International Conference on AI in Finance

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