SYSTEMIC RISK: THE EFFECT OF MARKET CONFIDENCE

Maxim Bichuch and Ke Chen ()
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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

International Journal of Theoretical and Applied Finance (IJTAF), 2020, vol. 23, issue 07, 1-39

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.

Keywords: Systemic risk; market confidence; overnight interest rate; Nash-equilibrium (search for similar items in EconPapers)
Date: 2020
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DOI: 10.1142/S0219024920500430

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