TY - CHAP
T1 - Liquidity and Solvency Risks in Financial Networks
AU - Zhao, Lingxiao
AU - Polukarov, Maria
AU - Ventre, Carmine
N1 - Publisher Copyright:
© 2023 ACM.
PY - 2023/11/27
Y1 - 2023/11/27
N2 - 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.
AB - 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.
UR - http://www.scopus.com/inward/record.url?scp=85179845554&partnerID=8YFLogxK
U2 - 10.1145/3604237.3626840
DO - 10.1145/3604237.3626840
M3 - Conference paper
SN - 9798400702402
T3 - ICAIF 2023 - 4th ACM International Conference on AI in Finance
SP - 210
EP - 218
BT - ICAIF 2023 - 4th ACM International Conference on AI in Finance
PB - ACM
ER -