Preventing Price-Mediated Contagion Due to Fire Sales Externalities: Strategic Foundations of Macroprudential Regulation

In economics and finance, most game theoretic frameworks are “classical” in that actors do not face any constraints. In this paper, we consider the case of banks that are financial institutions subject to capital ratio constraints. After an adverse shock, when the capital ratio of a given bank is lower than its minimum regulatory requirement, a bank will typically try to restore its capital ratio back above the minimum required by selling assets such as stocks and bonds. When the value of each asset decreases with the quantity sold, something called price impact in Finance, the capital ratio constraint of a given bank depends upon the asset sale of other banks. The deleveraging problem (asset sale) thus becomes a generalized game. We both consider the case of a generalized game under individual constraints (microprudential regulation) but also under shared constraint, interpreted as a macroprudential regulation from a financial point of view.