Shock amplification in an interconnected financial system of banks and investment funds

Matthias Sydow, Aurore Schilte, Giovanni Covi, Marija Deipenbrock, Leonardo Del Vecchio, Pawel Fiedor, Gábor Fukker, Max Gehrend, Régis Gourdel, Alberto Grassi, Björn Hilberg, Michiel Kaijser, Georgios Kaoudis, Luca Mingarelli, Mattia Montagna, Thibaut Piquard, Dilyara Salakhova and Natalia Tente

Journal of Financial Stability, 2024, vol. 71, issue C

Abstract: This paper shows how the combined endogenous reaction of banks and investment funds to an exogenous shock can amplify or dampen losses to the financial system compared to results from single-sector stress testing models. We build a new model of contagion propagation using a very large and granular data set for the euro area. Based on the economic shock caused by the Covid-19 outbreak, we model three sources of exogenous shocks: a default shock, a market shock and a redemption shock. Our contagion mechanism operates through a dual channel of liquidity and solvency risk. Our analysis reveals that adding the fund sector to our model for banks leads to additional losses through fire sales and a further depletion of banks’ capital ratios by around one percentage point. The main driver of additional bank losses are endogenous market losses generated by investment funds’ asset liquidation.

Keywords: Fire sales; Liquidity; Overlapping portfolios; Price impact; Stress testing (search for similar items in EconPapers)
JEL-codes: D85 G01 G21 G23 L14 (search for similar items in EconPapers)
Date: 2024
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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Working Paper: Shock amplification in an interconnected financial system of banks and investment funds (2021)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:finsta:v:71:y:2024:i:c:s1572308924000196

DOI: 10.1016/j.jfs.2024.101234

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