Fire sales, endogenous risk and price-mediated contagion: modeling, monitoring and prudential policy

Duration: 1 hour 2 mins

Share this media item:

Embed this media item:

<iframe width="_width_" height="_height_" src="https://sms.cam.ac.uk/media/1871484/embed" frameborder="0" scrolling="no" allowfullscreen></iframe>

Choose size:

About this item

Available Formats

About this item

Description:	Schaanning, E (Imperial College London) Tuesday 16 December 2014, 11:30-12:15


Created:	2015-01-22 14:29
Collection:	Systemic Risk: Mathematical Modelling and Interdisciplinary Approaches
Publisher:	Isaac Newton Institute
Copyright:	Schaanning, E
Language:	eng (English)


Abstract:	Co-author: Rama CONT (Imperial College London) Large-scale deleveraging of assets by distressed financial institutions have been recognized as an important channel for the contagion of losses during the recent financial crisis. We propose a model for analyzing the impact of fire sales on system-wide losses in a system with multiple financial institutions subject to a macroeconomic stress scenario affecting asset values. Our model emphasizes the nonlinear threshold nature of deleveraging, as a result of which the volume of deleveraging is a convex function of initial asset losses, and enables to quantify the magnitude of spillover effects due to price-mediated contagion in terms of liquidity-weighted overlaps of institutional asset holdings. We illustrate these observations on a dataset of European banks. A key concept which emerges from the model is the notion of indirect exposure of a financial institution to an asset class: we show that, when the impact of of fire sales is taken into account, the effective exposure of an institution to an asset class may be found to be much larger than the apparent exposure as revealed by the portfolio holdings alone. We show that regulatory risk weights of asset classes may be used as a macroprudential tool for a a decentralized regulation of fire sales risk, by providing incentives to financial institutions to reduce their exposure to this contagion channel without revealing confidential information on institutional portfolio holdings.

Abstract:

Co-author: Rama CONT (Imperial College London)

Large-scale deleveraging of assets by distressed financial institutions have been recognized as an important channel for the contagion of losses during the recent financial crisis. We propose a model for analyzing the impact of fire sales on system-wide losses in a system with multiple financial institutions subject to a macroeconomic stress scenario affecting asset values. Our model emphasizes the nonlinear threshold nature of deleveraging, as a result of which the volume of deleveraging is a convex function of initial asset losses, and enables to quantify the magnitude of spillover effects due to price-mediated contagion in terms of liquidity-weighted overlaps of institutional asset holdings. We illustrate these observations on a dataset of European banks.

A key concept which emerges from the model is the notion of indirect exposure of a financial institution to an asset class: we show that, when the impact of of fire sales is taken into account, the effective exposure of an institution to an asset class may be found to be much larger than the apparent exposure as revealed by the portfolio holdings alone. We show that regulatory risk weights of asset classes may be used as a macroprudential tool for a a decentralized regulation of fire sales risk, by providing incentives to financial institutions to reduce their exposure to this contagion channel without revealing confidential information on institutional portfolio holdings.

Available Formats

Format	Quality	Bitrate	Size
MPEG-4 Video	640x360	1.95 Mbits/sec	906.93 MB	View	Download
WebM	640x360	720.65 kbits/sec	327.25 MB	View	Download
iPod Video	480x270	524.5 kbits/sec	238.18 MB	View	Download
MP3	44100 Hz	251.16 kbits/sec	114.05 MB	Listen	Download
Auto *	(Allows browser to choose a format it supports)