Leveraging the network: A stress-test framework based on DebtRank

Stefano Battiston, Caldarelli Guido (), D’Errico Marco () and Gurciullo Stefano ()
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Caldarelli Guido: IMT Alti Studi Lucca, ISC-CNR, Rome, Italy; and LIMS London, United Kingdom of Great Britain and Northern Ireland
D’Errico Marco: Department of Banking and Finance, University of Zurich, Plattenstrasse 14, 8032 Zürich, Switzerland
Gurciullo Stefano: School of Public Policy, University College London, United Kingdom of Great Britain and Northern Ireland

Statistics & Risk Modeling, 2016, vol. 33, issue 3-4, 117-138

Abstract: We develop a novel stress-test framework to monitor systemic risk in financial systems. The modular structure of the framework allows to accommodate for a variety of shock scenarios, methods to estimate interbank exposures and mechanisms of distress propagation. The main features are as follows. First, the framework allows to estimate and disentangle not only first-round effects (i.e. shock on external assets) and second-round effects (i.e. distress induced in the interbank network), but also third-round effects induced by possible fire sales. Second, it allows to monitor at the same time the impact of shocks on individual or groups of financial institutions as well as their vulnerability to shocks on counterparties or certain asset classes. Third, it includes estimates for loss distributions, thus combining network effects with familiar risk measures such as VaR and CVaR. Fourth, in order to perform robustness analyses and cope with incomplete data, the framework features a module for the generation of sets of networks of interbank exposures that are coherent with the total lending and borrowing of each bank. As an illustration, we carry out a stress-test exercise on a dataset of listed European banks over the years 2008–2013. We find that second-round and third-round effects dominate first-round effects, therefore suggesting that most current stress-test frameworks might lead to a severe underestimation of systemic risk.

Keywords: Systemic risk; leverage network; stress-test (search for similar items in EconPapers)
Date: 2016
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Citations: View citations in EconPapers (28)

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Working Paper: Leveraging the network: a stress-test framework based on DebtRank (2016)
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DOI: 10.1515/strm-2015-0005

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