Asset firesale: Optimal market impact analysis

Multi-round loss estimations during the stress testing of financial institutions have brought to the fore the implications of losses from asset firesales both on the system and the seller.

Any decline in the value of the illiquid assets of a financial institution impacts regulatory metrics such as leverage negatively and compels deleveraging through firesales.

The ability to absorb such shocks varies, creating a gradation of stress that tips institutions into starting market operations.

While the weakest ones are typically the first to press sell, losses from firesales can trigger contagion and force even the stronger hands to exit.

In this paper, we leverage existing academic insights to create a holistic framework on how best to side-step such ructions.

If avoiding them completely is infeasible, we explore how to manage them effectively. We outline action points for banks, pension funds and asset managers to mitigate the impact of asset firesales through stress testing.