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We develop a framework for price-mediated contagion in financial systems where banks are forced to liquidate assets to satisfy a risk-weight based capital adequacy requirement. In constructing this modeling framework, we introduce a two-tier pricing structure: the volume weighted average price that is obtained by any bank liquidating assets and the terminal mark-to-market price used to account for all assets held at the end of the clearing process. We consider the case of multiple illiquid assets and develop conditions for the existence and uniqueness of clearing prices. We provide a closed-form representation for the sensitivity of these clearing prices to the system parameters, and use this result to quantify: (1) the cost of regulation, in stress scenarios, faced by the system as a whole and the individual banks, and (2) the value of providing bailouts to consider when such notions are financially advisable. Numerical case studies are provided to study the application of this model to data.

In this paper we present results on dynamic multivariate scalar risk measures, which arise in markets with transaction costs and systemic risk. Dual representations of such risk measures are presented. These are then used to obtain the main results of this paper on time consistency; namely, an equivalent recursive formulation of multivariate scalar risk measures to multiportfolio time consistency. We are motivated to study time consistency of multivariate scalar risk measures as the superhedging risk measure in markets with transaction costs (with a single eligible asset) (Jouini and Kallal (1995), Löhne and Rudloff (2014), Roux and Zastawniak (2016)) does not satisfy the usual scalar concept of time consistency. In fact, as demonstrated in (Feinstein and Rudloff (2021)), scalar risk measures with the same scalarization weight at all times would not be time consistent in general. The deduced recursive relation for the scalarizations of multiportfolio time consistent set-valued risk measures provided in this paper requires consideration of the entire family of scalarizations. In this way we develop a direct notion of a “moving scalarization” for scalar time consistency that corroborates recent research on scalarizations of dynamic multi-objective problems (Karnam, Ma and Zhang (2017), Kováčová and Rudloff (2021)).

Nash equilibria and Pareto optimality are two distinct concepts when dealing with multiple criteria. It is well known that the two concepts do not coincide. However, in this work we show that it is possible to characterize the set of all Nash equilibria for any non-cooperative game as the Pareto optimal solutions of a certain vector optimization problem. To accomplish this task, we increase the dimensionality of the objective function and formulate a non-convex ordering cone under which Nash equilibria are Pareto efficient. We demonstrate these results, first, for shared constraint games in which a joint constraint is applied to all players in a non-cooperative game. In doing so, we directly relate our proposed Pareto optimal solutions to the best response functions of each player. These results are then extended to generalized Nash games, where, in addition to providing an extension of the above characterization, we deduce two vector optimization problems providing necessary and sufficient conditions, respectively, for generalized Nash equilibria. Finally, we show that all prior results hold for vector-valued games as well. Multiple numerical examples are given and demonstrate that our proposed vector optimization formulation readily finds the set of all Nash equilibria.

In this paper, we construct a decentralized clearing mechanism which endogenously and automatically provides a claims resolution procedure. This mechanism can be used to clear a network of obligations through blockchain. In particular, we investigate default contagion in a network of smart contracts cleared through blockchain. In so doing, we provide an algorithm which constructs the blockchain so as to guarantee the payments can be verified and the miners earn a fee. We, additionally, consider the special case in which the blocks have unbounded capacity to provide a simple equilibrium clearing condition for the terminal net worths; existence and uniqueness are proven for this system. Finally, we consider the optimal bidding strategies for each firm in the network so that all firms are utility maximizers with respect to their terminal wealths. We first look for a mixed Nash equilibrium bidding strategies, and then also consider Pareto optimal bidding strategies. The implications of these strategies, and more broadly blockchain, on systemic risk are considered., 32 pages

Scalar dynamic risk measures for univariate positions in continuous time are commonly represented as backward stochastic differential equations. In the multivariate setting, dynamic risk measures have been defined and studied as families of set-valued functionals in the recent literature. There are two possible extensions of scalar backward stochastic differential equations for the set-valued framework: (1) backward stochastic differential inclusions, which evaluate the risk dynamics on the selectors of acceptable capital allocations; or (2) set-valued backward stochastic differential equations, which evaluate the risk dynamics on the full set of acceptable capital allocations as a singular object. In this work, the discrete time setting is investigated with difference inclusions and difference equations in order to provide insights for such differential representations for set-valued dynamic risk measures in continuous time., Comment: 27 pages

In this paper we consider continuity of the set of Nash equilibria and approximate Nash equilibria for parameterized games. For parameterized games with unique Nash equilibria, the continuity of this equilibrium mapping is well-known. However, when the equilibria need not be unique, there may exist discontinuities in the equilibrium mapping. The focus of this work is to summarize continuity properties for parameterized Nash equilibria and prove continuity via the approximate Nash game with uniformly continuous objective functions over potentially non-compact strategy spaces.

We propose a simple approach to bridge between portfolio theory and machine learning. The outcome is an out-of-sample machine learning efficient frontier based on two assets, high risk and low risk. By rotating between the two assets, we show that the proposed frontier dominates the mean–variance efficient frontier out-of-sample. Our results, therefore, shed important light on the appeal of machine learning into portfolio selection under estimation risk.

Endogenous Inverse Demand Functions Buying or selling assets in a financial market impacts the prices upward or downward. Quantifying these price impacts is fundamental to many problems within finance (e.g., optimal liquidation and systemic risk). In “Endogenous Inverse Demand Functions,” Bichuch and Feinstein construct an equilibrium risk sharing problem that results in an endogenous inverse demand function. This is taken in contrast to the often assumed exogenous linear or exponential forms for the inverse demand functions. The authors determine sufficient joint properties for the financial market and assets to replicate these common exogenous forms. The properties of the general endogenous inverse demand functions, found via the equilibrium risk sharing problem, are investigated; the authors deduce that price cross-impacts, which are often assumed to be zero, naturally arise in this equilibrium setting.

Nonzero sum games typically have multiple Nash equilibriums (or no equilibrium), and unlike the zero-sum case, they may have different values at different equilibriums. Instead of focusing on the existence of individual equilibriums, we study the set of values over all equilibriums, which we call the set value of the game. The set value is unique by nature and always exists (with possible value [Formula: see text]). Similar to the standard value function in control literature, it enjoys many nice properties, such as regularity, stability, and more importantly, the dynamic programming principle. There are two main features in order to obtain the dynamic programming principle: (i) we must use closed-loop controls (instead of open-loop controls); and (ii) we must allow for path dependent controls, even if the problem is in a state-dependent (Markovian) setting. We shall consider both discrete and continuous time models with finite time horizon. For the latter, we will also provide a duality approach through certain standard PDE (or path-dependent PDE), which is quite efficient for numerically computing the set value of the game.

"Raising liquidity when funding is stressed creates pressure on the financial market. Liquidating large quantities of assets depresses their prices and may amplify funding shocks. How do banks weathering a funding crisis contribute to contagion risk? We propose a model to study the transmission of distress in a banking system that has been hit by a funding shock. The model captures (1) the indirect effects of price impacts due to the optimal reinvestment of banks’ asset mixture and (2) the direct network effects if banks cannot fully pay back their interbank exposures. We demonstrate how banks liquidate assets in equilibrium and at what price, and we examine the role of regulators in stabilizing prices in a funding crisis. Our empirical results, based on the Canadian supervisory data, show that even very large funding shocks are unlikely to trigger a cascade of defaults. However, losses incurred on liquidated assets in fire sales may be substantial. Nevertheless, banks are less likely to overreact or sell more than strictly necessary when they take other banks' actions into account. ", "Mobiliser des liquidités lorsqu’il y a des difficultés de financement exerce des pressions sur le marché financier. Liquider de grandes quantités d’actifs fait baisser leur prix et peut amplifier les chocs de financement. Comment les mesures prises par les banques pour surmonter une crise de financement accroissent-elles le risque de contagion? Nous proposons un modèle permettant d’étudier la transmission des difficultés au sein d’un système bancaire ébranlé par un choc de financement. Le modèle prend en compte 1) les effets indirects qui découlent de l’incidence sur les prix d’un réinvestissement optimal de l’actif des banques et 2) les effets de réseau observés si les banques ne sont pas en mesure de rembourser tout ce qu’elles doivent aux autres banques (expositions interbancaires directes). Nous démontrons comment, et à quel prix, les banques liquident leurs actifs à l’équilibre, et examinons le rôle des organismes de réglementation sur la stabilisation des prix pendant une crise de financement. Nos résultats empiriques, basés sur les données de l’autorité canadienne de surveillance, révèlent que même des chocs de financement de très grande ampleur sont peu susceptibles de déclencher des défauts en cascade. Cependant, les pertes attribuables à la liquidation d’actifs en catastrophe pourraient être substantielles. Néanmoins, une banque a moins tendance à réagir de manière excessive ou à vendre plus que le strict nécessaire quand elle prend en compte les actions des autres banques."

The equivalence between multiportfolio time consistency of a dynamic multivariate risk measure and a supermartingale property is proven. Furthermore, the dual variables under which this set-valued supermartingale is a martingale are characterized as the worst-case dual variables in the dual representation of the risk measure. Examples of multivariate risk measures satisfying the supermartingale property are given. Crucial for obtaining the results are dual representations of scalarizations of set-valued dynamic risk measures, which are of independent interest in the fast growing literature on multivariate risks., 40 pages

We quantify the sensitivity of the Eisenberg-Noe clearing vector to estimation errors in the bilateral liabilities of a financial system in a stylized setting. The interbank liabilities matrix is a crucial input to the computation of the clearing vector. However, in practice central bankers and regulators must often estimate this matrix because complete information on bilateral liabilities is rarely available. As a result, the clearing vector may suffer from estimation errors in the liabilities matrix. We quantify the clearing vector's sensitivity to such estimation errors and show that its directional derivatives are, like the clearing vector itself, solutions of fixed point equations. We describe estimation errors utilizing a basis for the space of matrices representing permissible perturbations and derive analytical solutions to the maximal deviations of the Eisenberg-Noe clearing vector. This allows us to compute upper bounds for the worst case perturbations of the clearing vector in our simple setting. Moreover, we quantify the probability of observing clearing vector deviations of a certain magnitude, for uniformly or normally distributed errors in the relative liability matrix. Applying our methodology to a dataset of European banks, we find that perturbations to the relative liabilities can result in economically sizeable differences that could lead to an underestimation of the risk of contagion. Our results are a first step towards allowing regulators to quantify errors in their simulations., Comment: 37 pages

Systemic risk refers to the risk that the financial system is susceptible to failures due to the characteristics of the system itself. The tremendous cost of systemic risk requires the design and implementation of tools for the efficient macroprudential regulation of financial institutions. The current paper proposes a novel approach to measuring systemic risk. Key to our construction is a rigorous derivation of systemic risk measures from the structure of the underlying system and the objectives of a financial regulator. The suggested systemic risk measures express systemic risk in terms of capital endowments of the financial firms. Their definition requires two ingredients: a cash flow or value model that assigns to the capital allocations of the entities in the system a relevant stochastic outcome; and an acceptability criterion, i.e. a set of random outcomes that are acceptable to a regulatory authority. Systemic risk is measured by the set of allocations of additional capital that lead to acceptable outcomes. We explain the conceptual framework and the definition of systemic risk measures, provide an algorithm for their computation, and illustrate their application in numerical case studies. Many systemic risk measures in the literature can be viewed as the minimal amount of capital that is needed to make the system acceptable after aggregating individual risks, hence quantify the costs of a bail-out. In contrast, our approach emphasizes operational systemic risk measures that include both ex post bailout costs as well as ex ante capital requirements and may be used to prevent systemic crises., Comment: 35 pages, 11 figures

In this paper we present results on scalar risk measures in markets with transaction costs. Such risk measures are defined as the minimal capital requirements in the cash asset. First, some results are provided on the dual representation of such risk measures, with particular emphasis given on the space of dual variables as (equivalent) martingale measures and prices consistent with the market model. Then, these dual representations are used to obtain the main results of this paper on time consistency for scalar risk measures in markets with frictions. It is well known from the superhedging risk measure in markets with transaction costs, as in Jouini and Kallal (1995), Roux and Zastawniak (2016), and Loehne and Rudloff (2014), that the usual scalar concept of time consistency is too strong and not satisfied. We will show that a weaker notion of time consistency can be defined, which corresponds to the usual scalar time consistency but under any fixed consistent pricing process. We will prove the equivalence of this weaker notion of time consistency and a certain type of backward recursion with respect to the underlying risk measure with a fixed consistent pricing process. Several examples are given, with special emphasis on the superhedging risk measure.

In this paper we study the implications of contingent payments on the clearing wealth in a network model of financial contagion. We consider an extension of the Eisenberg–Noe financial contagion model in which the nominal interbank obligations depend on the wealth of the firms in the network. We first consider the problem in a static framework and develop conditions for existence and uniqueness of solutions as long as no firm is speculating on the failure of other firms. In order to achieve existence and uniqueness under more general conditions, we introduce a dynamic framework. We demonstrate how this dynamic framework can be applied to problems that were ill-defined in the static framework.

We construct a continuous time model for price-mediated contagion precipitated by a common exogenous stress to the banking book of all firms in the financial system. In this setting, firms are constrained so as to satisfy a risk-weight based capital ratio requirement. We use this model to find analytical bounds on the risk-weights for assets as a function of the market liquidity. Under these appropriate risk-weights, we find existence and uniqueness for the joint system of firm behavior and the asset prices. We further consider an analytical bound on the firm liquidations, which allows us to construct exact formulas for stress testing the financial system with deterministic or random stresses. Numerical case studies are provided to demonstrate various implications of this model and analytical bounds.

Valuing Debt and Equity in Interbank Networks Valuation adjustments to account for, for example, counterparty risk, have become an important part of derivative valuation by any bank since the 2007–2009 financial crisis. As evidenced by that crisis, considering the risk of a single firm alone can cause gross misspecification of firm health. In “Pricing of Debt and Equity in a Financial Network with Comonotonic Endowments,” Banerjee and Feinstein construct an analytical formulation for a valuation adjustment that takes the entire network of counterparty obligations into account when all institutions have comonotonic endowments. From the perspective of stress testing, such a setting corresponds to a systematic shock to all firms. This comonotonic setting is then shown to provide computationally tractable upper and lower bounds to the general network valuation problem. The authors demonstrate that the comonotonic endowment setting arises endogenously in a system of equity maximizing firms.

This paper provides a framework for modeling financial contagion in a network subject to fire sales and price impacts, but allowing for firms to borrow to cover their shortfall as well. We consider both uncollateralized and collateralized loans. The main results of this work are providing sufficient conditions for existence and uniqueness of the clearing solutions (i.e., payments, liquidations, and borrowing); in such a setting any clearing solution is the Nash equilibrium of an aggregation game.

We present a novel framework for evaluating the risk of failures in power transmission systems. We use the concept of systemic risk measures from the financial mathematics literature with models of power system failures in order to quantify the risk of the entire power system for design and comparative purposes. The proposed risk measures provide the collection of capacity vectors for the components in the system that lead to acceptable outcomes. Keys to the formulation of our measures of risk are two elements: a model of system behavior that provides the (distribution of) outcomes based on component capacities and an acceptability criterion that determines whether a (random) outcome is acceptable from an aggregated point of view. We examine the effects of altering the line capacities on energy not served under a variety of networks, flow manipulation methods, load shedding schemes, and load profiles using Monte Carlo simulations. Our results provide a quantitative comparison of the performance of these schemes, measured by the required line capacity. These results provide more complete descriptions of the risks of power failures than the previous, one-dimensional metrics.

This paper provides a framework for modeling the financial system with multiple illiquid assets when liquidation of illiquid assets is caused by failure to meet a leverage requirement. This extends the network model of Cifuentes, Shin & Ferrucci (2005) which incorporates a single asset with fire sales and capital adequacy ratio. This also extends the network model of Feinstein (2015) which incorporates multiple illiquid assets with fire sales and no leverage ratios. We prove existence of equilibrium clearing payments and liquidation prices for a known liquidation strategy when leverage requirements are required. We also prove sufficient conditions for the existence of an equilibrium liquidation strategy with corresponding clearing payments and liquidation prices. Finally we calibrate network models to asset and liability data for 50 banks in the United States from 2007-2014 in order to draw conclusions on systemic risk as a function of leverage requirements., 38 pages, 23 figures

A method for calculating multi-portfolio time consistent multivariate risk measures in discrete time is presented. Market models for $d$ assets with transaction costs or illiquidity and possible trading constraints are considered on a finite probability space. The set of capital requirements at each time and state is calculated recursively backwards in time along the event tree. We motivate why the proposed procedure can be seen as a set-valued Bellman's principle, that might be of independent interest within the growing field of set optimization. We give conditions under which the backwards calculation of the sets reduces to solving a sequence of linear, respectively convex vector optimization problems. Numerical examples are given and include superhedging under illiquidity, the set-valued entropic risk measure, and the multi-portfolio time consistent version of the relaxed worst case risk measure and of the set-valued average value at risk., Comment: 25 pages, 5 figures

This paper contains an overview of results for dynamic multivariate risk measures. We provide the main results of four different approaches. We will prove under which assumptions results within these approaches coincide, and how properties like primal and dual representation and time consistency in the different approaches compare to each other.

This paper provides a framework for modeling the financial system with multiple illiquid assets during a crisis. This work generalizes the paper by Amini, Filipovic and Minca (2016) by allowing for differing liquidation strategies. The main result is a proof of sufficient conditions for the existence of an equilibrium liquidation strategy with corresponding unique clearing payments and liquidation prices. An algorithm for computing the maximal clearing payments and prices is provided., Comment: 8 pages