Liquidity and Equity Short Term Fragility: Stress Tests for the European Banking System

Abstract

This paper investigates the impact of extreme shocks on stock and bond markets on listed European banks. The originality of our approach consists in dealing jointly with stock and bond markets and taking into account their interdependencies in case of extreme events by using a specific CVRF (CVine Risk Factor) model which combines copulas and a factorial structure. Moreover, contrary to what is generally done in the literature, we do not focus only on the responses of the stock returns but we also examine the response of the balance sheets of the banks and particularly of their short term assets in order to assess their fragility in terms of liquidity. Our main findings are the following: 1) the nature of the banks' fragility has changed: today, the interest rate risk should be the first concern before the equity risk, as the banks have extensively increased their exposition to bond market due to flightto-quality reactions and to large investments in governments bonds after the rescue operations the banks have benefited; 2) in case of a surge in the interest rate and in the links between stock and bond returns, the portfolios of the biggest banks in Europe would experience very severe shortfalls for both equity and liquidity buffers. Accordingly regulators should monitor the evolution of dependencies between assets and should pay utmost attention to the positive links between stock and bond returns.

How did regulation and market discipline influence banking distress in Europe?

“…This aspect gains importance if we project the impact that the end of this loosening monetary policy could have on the banking system. This can have an even more negative impact in the case in which correlations between bonds and equity start to become positive, thus reducing the opportunities to diversify (Arnould et al, 2017). Thus the change of the regulatory treatment of sovereign debt, advocated by Kahlert and Wagner (2017), discussed further in this paper, gains additional relevance.…”

“…This lasting low-interest-rate environment stemming from an accommodative monetary policy adopted by the European Central Bank may prompt a search for yield behaviour by the economic agents, which in turn, might foster investment in complex products with higher yields but also higher risk, a behaviour that, according to Breitenfellner and Wagner (2010), underpinned the global financial crisis. Additionally, the flight-to-quality behaviour carried out by banks characterized by large investments in government bonds as a consequence, on the one hand of the rescue operations the banks have beneted, and, on the other hand, from the new liquidity requirements, has increased their exposition to interest rate risk as found by Arnould et al (2017). This aspect gains importance if we project the impact that the end of this loosening monetary policy could have on the banking system.…”