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Systemic Risk: The Effect Of Market Confidence

Author

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  • MAXIM BICHUCH

    (Department of Applied Mathematics and Statistics, Whiting School of Engineering, Johns Hopkins University, 3400 North Charles St., Baltimore, MD 21218, USA)

  • KE CHEN

    (Department of Applied Mathematics and Statistics, Whiting School of Engineering, Johns Hopkins University, 3400 North Charles St., Baltimore, MD 21218, USA)

Abstract

In a crisis, when faced with insolvency, banks can sell stock in a dilutive offering in the stock market and borrow money in order to raise funds. We propose a simple model to find the maximum amount of new funds the banks can raise in these ways. To do this, we incorporate market confidence of the bank together with market confidence of all the other banks in the system into the overnight borrowing rate. Additionally, for a given cash shortfall, we find the optimal mix of borrowing and stock selling strategy. We show the existence and uniqueness of Nash equilibrium point for all these problems. Finally, using this model we investigate if banks have become safer since the crisis. We calibrate this model with market data and conduct an empirical study to assess safety of the financial system before, during after the last financial crisis.

Suggested Citation

  • Maxim Bichuch & Ke Chen, 2020. "Systemic Risk: The Effect Of Market Confidence," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 23(07), pages 1-39, November.
    • Handle: RePEc:wsi:ijtafx:v:23:y:2020:i:07:n:s0219024920500430
    DOI: 10.1142/S0219024920500430
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    Cited by:

    1. Bichuch, Maxim & Feinstein, Zachary, 2022. "A repo model of fire sales with VWAP and LOB pricing mechanisms," European Journal of Operational Research, Elsevier, vol. 296(1), pages 353-367.

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