Suffocating Fire Sales

Fire sales are among the major drivers of market instability in modern financial systems. Due to iterated distressed selling and the associated price impact, initial shocks to some institutions can be amplified dramatically through the network induced by portfolio overlaps. In this paper we develop models that allow us to investigate central characteristics that drive or hinder the propagation of distress. We investigate single systems as well as ensembles of systems that are alike, where similarity is measured in terms of the empirical distribution of all defining properties of a system. This asymptotic approach ensures a great deal of robustness to statistical uncertainty and temporal fluctuations, and we give various applications. A natural characterization of systems resilient to fire sales emerges, and we provide explicit criteria that regulators may exploit in order to assess the stability of any system. Moreover, we propose risk management guidelines in form of minimal capital requirements, and we investigate the effect of portfolio diversification and portfolio overlap. We test our results by Monte Carlo simulations for exemplary configurations.