Contagion Accounting

Summary

Focus

Banking sector interconnectedness and contagion materialize in more than one way. The most obvious is the direct exposures between banks. However, the fate of seemingly disconnected and geographically dispersed institutions can still be bound together due to the importance of indirect contagion. Most important within such interconnections are exposures to the same assets and to externalities driven by fire sales. The importance of each contagion channel remains a contested issue and is ultimately an empirical question.

Contribution

We provide a simple and tractable accounting-based stress-testing framework to assess loss dynamics in a banking sector connected via direct interbank exposures and common asset holdings (ie overlapping portfolios). We develop measures that allow for the computation of losses stemming from network exposures, as well as additional losses generated by fire sale dynamics. In this way, we can account for the contribution to system losses of each contagion channel. We apply our framework to detailed micro-financial euro area data.

Findings

We find that interbank exposures account for only a minor share of the overall losses due to contagion. Aside from the direct effect of shocks to the value of assets on the trading book, common exposures that make banks vulnerable to fire sales and synchronous price dislocations account for the bulk of distress contagion. The calibration of the price impact of fire sales is a critical input to determine the extent of losses. Stress-testing exercises would greatly benefit from more efforts to improve such calibrations.

Abstract

We provide a simple and tractable accounting-based stress-testing framework to assess loss dynamics in the banking sector, in a context of leverage targeting. Contagion can occur through direct interbank exposures, and indirect exposures due to overlapping portfolios with the associated price dynamics via fire sales. We apply the framework to three granular proprietary ECB datasets, including an interbank network of 26 large euro area banks as well as their overlapping portfolios of loans, derivatives and securities. A 5 percent shock to the price of assets held in the trading book leads to an initial loss of 30 percent of system equity and an additional loss of 1.3 percent due to fire sales spillovers. Direct interbank contagion is negligible in our analysis. Our findings underscore the importance of accurately estimating the price effects of fire sales.

JEL Codes: C63, G01, G18, G21

Keywords: interbank networks, contagion, overlapping portfolios, fire sales, stress-testing