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On the origin of systemic risk

Mattia Montagna (), Gabriele Torri () and Giovanni Covi ()
Additional contact information
Mattia Montagna: European Central Bank
Gabriele Torri: University of Bergamo

No 906, Bank of England working papers from Bank of England

Abstract: Systemic risk in the banking sector is usually associated with long periods of economic downturn and very large social costs. On one hand, shocks coming from correlated exposures towards the real economy may induce correlation in banks’ default probabilities thereby increasing the likelihood for systemic tail events like the 2008 Great Financial Crisis. On the other hand, financial contagion also plays an important role in generating large-scale market failures, amplifying the initial shocks coming from the real economy. To study the sources of these rare phenomena, we propose a new definition of systemic risk (ie the probability of a large number of banks going into distress simultaneously) and thus we develop a multilayer microstructural model to study empirically the determinants of systemic risk. The model is then calibrated on the most comprehensive granular dataset for the euro-area banking sector, capturing roughly 96% or €23.2 trillion of euro-area banks’ total assets over the period 2014–2018. The outputs of the model decompose and quantify the sources of systemic risk showing that correlated economic shocks, financial contagion mechanisms, and their interaction are the main sources of systemic events. The results obtained with the simulation engine resemble common market-based systemic risk indicators and empirically corroborate findings from existing literature. This framework gives regulators and central bankers a tool to study systemic risk and its developments, pointing out that systemic events and banks’ idiosyncratic defaults have different drivers, hence implying different policy responses.

Keywords: Systemic risk; financial contagion; microstructural models (search for similar items in EconPapers)
JEL-codes: D85 G17 G33 L14 (search for similar items in EconPapers)
Pages: 49 pages
Date: 2021-01-29
New Economics Papers: this item is included in nep-ban, nep-cba, nep-cfn, nep-cwa, nep-fdg, nep-fmk and nep-rmg
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Working Paper: On the origin of systemic risk (2020) Downloads
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