Modelling Fire Sale Contagion Across Banks and Non-banks

Abstract

We study the impact of common asset holdings across different financial sectors on financial stability. In particular, we model indirect contagion via fire sales across UK banks and non-banks. Fire sales are triggered by different responses to a financial shock: banks and non unit-linked insurers are subject to regulatory constraints, while funds and unit-linked insurers are obliged to meet investor redemptions. We use our model to conduct a systemic stress simulation under different initial shock scenarios and institutions' selling strategies. We find that performing a stress simulation that does not account for common asset holdings across multiple sectors can severely underestimate the fire sale losses in the financial system.

Banks' Strategic Interaction, Adverse Price Dynamics and Systemic Liquidity Risk

“…Another area for improving the current framework is to integrate the interactions between banks and other sectors of the financial system or the real economy. Caccioli, Ferrara, and Ramadiah (2021) find that ignoring the common asset holdings between banks and the non-banks financial sector can significantly underestimate losses in distressed sales. In this vein, Deutsche Bundesbank (2020) shows that other financial intermediaries, such as insurance companies or mutual funds, often played a key role during past liquidity crises.…”

Non-Banks Contagion and the Uneven Mitigation of Climate Risk

“…Coarse shocks such as a uniform change in the yields of bonds are standard in the stress testing literature where the focus is on the model and not on the scenario. 24 Using it The unweighted average is taken as a simple mean of the carbon intensity or physical risk index respectively. These two variables are the ones defined in section 3.…”

“…It is not the only measure of portfolio similarity available though. For instance, Caccioli et al [24] use it jointly with a BinSimilarity measure, which is an unweighted count of the number of holdings that are common to both institutions' portfolios.…”

Contagion from Market Price Impact: A Price-at-Risk Perspective

“…While in Cont and Wagalath (2016) the authors develop an econometric framework for the forensic analysis of fire sales episodes, which is characterized by an exponential price impact form. This same exponential function has been implemented in several publications on spillover effects and contagion due to portfolio deleveraging and fire sales (Cont and Schaanning, 2017;Caccioli, Ferrara, and Ramadiah, 2020)). However, to our knowledge, price impact, by means of capturing quantiles of the entire distribution in combination with an exponential impact function to model contagion from large scale portfolio deleveraging, has not been introduced yet.…”