Strategic foundations of macroprudential regulation : preventing fire sales externalities

We offer a stress test framework in which interaction between regulated banks occurs through pecuniary externalities when they delever. Since banks are constrained to maintain their capital ratio higher than a threshold, the deleveraging problem yields a generalized game in which the solvency constraint of each bank depends upon the decisions of the others. We analyze the game under microprudential but also under macroprudential regulation in which fire sales externalities are banned. We show that a Pareto optimal Nash equilibrium generically exists under macroprudential regulation while the existence under microprudential regulation requires strong conditions. An empirical analysis is also provided