Fire Sales, Indirect Contagion and Systemic Stress-Testing

Cont, Rama; Schaanning, Eric

doi:10.2139/ssrn.2541114

Cited by 59 publications

(121 citation statements)

References 39 publications

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“…In this paper we focus on direct exposures as a means of financial contagion. However, we note that our framework could be extended to other cases, like those of rollover risk 40 or overlapping portfolios 24 . In the case of rollover risk, internal assets would be short term interbank assets, and the matrix of interbank leverage would be replaced by its transpose.…”

Section: Resultsmentioning

confidence: 99%

“…Many different algorithms have since then been developed to model the propagation of distress between banks under different assumptions as well as to study the relation between the structure of a financial network and its stability (see for instance 3,[5][6][7][8][9][10][11][12][13][14][15][16][17][18][19][20][21] ). In this respect, significant progress has been made in the identification of the main drivers of financial contagion and in the design of new stress test frameworks that, at odds with standard micro-prudential tools, do account for interactions between banks 13,[21][22][23][24][25][26] . While the focus of research carried out so far has been mainly that of developing models to understand how exogenous shocks are amplified by the endogenous dynamics of the system, here we look at the reverse problem.…”

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confidence: 99%

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Reverse Stress Testing Interbank Networks

Grigat

Caccioli

2017

SSRN Journal

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We reverse engineer dynamics of financial contagion to find the scenario of smallest exogenous shock that, should it occur, would lead to a given final systemic loss. This reverse stress test can be used to identify the potential triggers of systemic events, and it removes the arbitrariness in the selection of shock scenarios in stress testing. We consider in particular the case of distress propagation in an interbank market, and we study a network of 44 European banks, which we reconstruct using data collected from banks statements. By looking at the distribution across banks of the size of smallest exogenous shocks we rank banks in terms of their systemic importance, and we show the effectiveness of a policy with capital requirements based on this ranking. We also study the properties of smallest exogenous shocks as a function of the parameters that determine the endogenous amplification of shocks. We find that the size of smallest exogenous shocks reduces and that the distribution across banks becomes more localized as the system becomes more unstable.Systemic risk -the risk associated with the occurrence of a catastrophic breakdown of the financial systemarises endogenously from interactions between the participants that operate in financial markets. Because some types of interactions between financial institutions (in the following banks for brevity) can be modeled in terms of dynamical processes on networks, a growing body of literature has focused on the study of contagion and distress propagation in financial networks [1][2][3] . This research began in the year 2000 with the work of Allen and Gale, who showed that the topology of financial networks influences financial contagion 4 . Many different algorithms have since then been developed to model the propagation of distress between banks under different assumptions as well as to study the relation between the structure of a financial network and its stability (see for instance 3,[5][6][7][8][9][10][11][12][13][14][15][16][17][18][19][20][21] ). In this respect, significant progress has been made in the identification of the main drivers of financial contagion and in the design of new stress test frameworks that, at odds with standard micro-prudential tools, do account for interactions between banks 13,[21][22][23][24][25][26] . While the focus of research carried out so far has been mainly that of developing models to understand how exogenous shocks are amplified by the endogenous dynamics of the system, here we look at the reverse problem. We compute the time trajectories of smallest shocks that need to affect banks to produce a final loss of equity larger than a given threshold, which we therefore refer to as worst case shocks. The solution of this reverse problem is useful to identify stress scenarios whose occurrence would lead to systemic events, thus identifying the vulnerabilities of a financial system.At the level of individual institutions, reverse stress testing is a regulatory requirement in the United Kingdom (UK) and the European Union. The...

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Section: Resultsmentioning

confidence: 99%

mentioning

confidence: 99%

Reverse Stress Testing Interbank Networks

Grigat

Caccioli

2017

SSRN Journal

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“…This VWAP lies somewhere between the pre-and post-fire-sales prices. In the empirical examples below, we will use 1/2, which corresponds to a VWAP midway between the pre-and postfire-sales prices, following Cont and Schaanning (2017). Therefore, bank 's losses in regime (nonstress or stress) can be written as:…”

Section: Solvency: Asset Valuation and Lossesmentioning

confidence: 99%

Integrating Solvency and Liquidity Stress Tests

Han

Leika

2019

IMF Working Papers

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The paper presents a framework to integrate liquidity and solvency stress tests. An empirical study based on European bond trading data finds that asset sales haircuts depend on the total amount of assets sold and general liquidity conditions in the market. To account for variations in market liquidity, the study uses Markov regime-switching models and links haircuts with market volatility and the amount of securities sold by banks. The framework is accompanied by a Matlab program and an Excel-based tool, which allow the calculations to be replicated for any type of traded security and to be used for liquidity and solvency stress testing.

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“…Cont and Schaanning [67] consider a dynamic which is in between that of a passive investor and a leverage targeting one. In their model, they account for the fact that there is usually a buffer between the leverage of a bank and the maximum leverage allowed by regulation.…”

Section: Leverage Targetingmentioning

confidence: 99%

“…Deleveraging only involves marketable securities. [67] consider data collected by the European Banking Authority on 51 European banks, and they compare the outcome of stress tests performing with their model vs. target leveraging. In terms of price changes, they consider both a linear and square root market impact.…”

Section: Leverage Targetingmentioning

confidence: 99%

Network models of financial systemic risk: a review

2017

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The global financial system can be represented as a large complex network in which banks, hedge funds and other financial institutions are interconnected to each other through visible and invisible financial linkages. Recently, a lot of attention has been paid to the understanding of the mechanisms that can lead to a breakdown of this network. This can happen when the existing financial links turn from being a means of risk diversification to channels for the propagation of risk across financial institutions. In this review article, we summarize recent developments in the modeling of financial systemic risk. We focus, in particular, on network approaches, such as models of default cascades due to bilateral exposures or to overlapping portfolios, and we also report on recent findings on the empirical structure of interbank networks. The current review provides a landscape of the newly arising interdisciplinary field lying at the intersection of several disciplines, such as network science, physics, engineering, economics, and ecology.

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Fire Sales, Indirect Contagion and Systemic Stress-Testing

Cited by 59 publications

References 39 publications

Reverse Stress Testing Interbank Networks

Reverse Stress Testing Interbank Networks

Integrating Solvency and Liquidity Stress Tests

Network models of financial systemic risk: a review

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