## Risk amplification mechanisms in the financial system — Rama CONT

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### Stress testing and risk modeling: micro to macro
- Microprudential stress testing:
  - exogenous shocks applied to bank portfolio to assess adequacy of capital/liquidity
- “Macro stress testing”:
  - shocks to macroeconomic variables affect all banks
  - shocks to asset values derived from shocks to macroeconomic variables
  - accounts for systematic risk/common exposures
  - does not account for contagion effects/loss amplification
- Systemic / Macroprudential stress testing:
  - initial stress applied to macroeconomic variables
  - shocks to asset values derived from shocks to macroeconomic variables
  - focus on mechanisms which lead to systemic risk/financial instability
  - explicit modeling of contagion channels and loss amplification mechanisms

### Channels of loss amplification which contribute to systemic risk
- Counterparty Risk: loss contagion through asset side
- Funding channel: loss contagion through liability side
- Feedback effects from fire sales: loss contagion through mark-to-market losses in common asset holdings
- These loss contagion mechanisms may arise before any default occurs (unlike earlier default contagion models).
- Regulatory measures have focused on:
  - counterparty exposures (large exposure limits, central clearing, CVA, ring-fencing)
  - funding/liquidity (LCR, NSFR)
- Arguments for supervisory bank stress tests to include these channels.
- Most studies focus on a single channel but channels interact and amplify each other.
- Most models focus either on (in)solvency or (il)liquidity but not on their interaction.

### Illiquidity: cause or symptom?
- Legal definition of ‘default’ corresponds to ‘default on payments’ = illiquidity.
- Credit risk models often define failure as insolvency.
- Most recent bank failures involved failure to meet a margin call due to lack of liquid assets/cash/funding.
- Regulatory focus has moved to liquidity regulation and liquidity stress testing, separately from capital adequacy.
- Liquidity arises from repo or asset-backed borrowing, linking it back to asset value/solvency: liquidity and solvency are intimately linked and cannot be modeled/regulated independently.
- Bagehot principle: Lender of last resort should lend to solvent banks, at a penalty.
- More work needed on interaction of liquidity and solvency and implications for realistic stress testing.

### Contagion and systemic risk in financial networks (Direct contagion)
- Balance sheet contagion through:
  - exposures → counterparty risk → insolvency cascades
  - funding relations → funding risk → illiquidity contagion (institutional bank runs)
- New regulations focus: Large exposure limits, collateral requirements, CVA, LCR and diversification of funding (NSFR).
- Targeted capital requirements:
  - Due to heterogeneity of exposure networks, loss transmission is channeled through “large exposures” and suggests limits/charges on large exposures (Cont, Moussa, Santos 2013).
- Comparison of capital requirement policies examined:
  - (a) uniform capital ratio for all institutions in the network
  - (b) higher capital ratio for the 5% most systemic institutions (SIFIs)
  - (c) uniform capital-to-exposure ratio
  - (d) capital-to-exposure ratio for the 5% most systemic institutions
  - Focus: targeted capital requirements by identifying weak links.

### Indirect contagion: fire sales and feedback effects
- Distressed institutions subject to (capital, liquidity, leverage) constraints sell assets according to liquidity.
- Asset sales by distressed institutions push down prices and generate mark-to-market losses for institutions holding similar assets.
- This can trigger further deleveraging and generate a destabilizing feedback loop.

### Systemic stress testing with fire sales spillovers (Cont & Schaanning 2015)
- Framework:
  - N institutions (banks or not) with holdings across k assets
  - Inputs: holdings of institutions by asset class
  - Macro-economic shock ε affects (some) asset values
  - If loss of portfolio j exceeds a threshold, institution deleverages by selling assets
  - Assumption: proportional deleveraging to restore portfolio leverage to a buffer level: Q_ij(ε) = volume of sales of asset i by j
  - Total volume of fire sales in asset i: Q_i(ε) = Σ_j Q_ij(ε)
  - Fire sales affect prices through market impact; price changes generate losses in all portfolios exposed to these assets and may generate further deleveraging
- Empirical insights (EBA data; Cont & Schaanning 2015):
  - Number of EU banks pass the stand-alone stress test but fail to have enough capital to face fire-sales losses due to indirect contagion
  - Bank-level losses in a systemic stress test with fire sales can be 10 to 100 times larger for some banks compared with a stress test without fire sales whose severity is scaled to match total loss (Cont & Schaanning 2015; Data: EBA 2011)
  - Indirect contagion effects cannot necessarily be replicated simply by more severe non-contagion stress scenarios.

### Threshold nature and mechanics of fire-sales contagion
- Fire-sales lead to indirect exposures:
  - Example: non-bank A and bank B hold common asset 1; A holds illiquid asset 2 that B does not hold.
  - Notional exposure of B to asset 2 is zero, but a large shock to asset 2 may force A to sell asset 1, lowering its price and causing market losses for B.
  - B therefore has an indirect exposure to asset 2 via portfolio overlap.
- Magnitude of indirect exposure linked to overlap between B and institutions holding the illiquid asset.
- Large diversified institutions increase overlaps across the system and become nodes for price-mediated contagion.

### Measuring effective (indirect) exposures
- Effective exposure of institution i to asset class ℓ under scenario 's' is given by:
  - E_{i,ℓ}(s) := Loss(i,ℓ,s) / Notional exposure + FLoss(i,ℓ,s) / Notional exposure
  - where FLoss(i,ℓ,s) is the total fire-sales loss that i suffers as a result of the shock s to asset class ℓ.
- The effective exposure is scenario dependent and accounts for network-dependent losses; it reflects the network-dependent (and actual) risk of i’s portfolio.

### Dissemination and monitoring of indirect exposures
- Indirect exposures of UK banks to Spanish mortgages and other cross-border indirect exposures can be significant (EBA data; authors’ calculations).
- Indirect exposures are significant in magnitude: EU banks have significant indirect exposure to non-domestic housing prices.
- Risk of a bank portfolio cannot be computed simply from notional positions; it is the outcome of a network-wide stress test depending on configuration of portfolios of other large financial institutions.
- Disclosure of indirect exposures, computed in a systemic stress test, to each institution gives them an element to internalize/manage this risk.

### Financial stability beyond the banking system
- Majority of assets in the world financial system held outside the banking system: insurance, asset managers, pension funds.
  - Example: European insurance sector holds 6.8 Trillion EUR in assets.
- Tighter bank regulation has pushed many activities outside the banking sector.
- Distinction between banks and non-banks is related to supervisory and legal regime but loss contagion mechanisms also affect non-banks; losses outside banking can destabilize banks (AIG 2008).
- Major non-bank financial institutions should be included in system-wide stress tests focused on financial stability.
- Diversity of business models: non-banks have different business models and reactions to stress so banking policy tools (e.g., capital requirements) may not be relevant or meaningful. Examples: CCPs, insurance (ALM constraints), asset managers (redemption risk).
- Diversity of business models and regulatory regimes can be a stabilizing factor: institutions with same constraints tend to react similarly to stress scenarios — argument against uniform/overly prescriptive regulations (examples: Solvency II / Basel III).

### Governance of Macroprudential stress tests
- Three proposed avenues:
  1. Dissemination of results: making invisible risks visible
     - To regulators: more realistic assessment of systemic risk and financial stability (bank stress tests, IMF FSAP)
     - To financial institutions: many are not aware of magnitude and nature of their exposures to systemic risk as this requires information only available to regulators
     - Dissemination of systemic stress test outcomes to institutions — their own exposures to stress scenarios and contagion channels — can help improve risk governance
  2. Implications for capital adequacy:
     - Capital adequacy should be reexamined by accounting for all risks, not just ‘microprudential’ stress tests
  3. Cost-benefit analysis of macroprudential regulation:
     - Macroprudential stress tests can offer a meaningful approach to assessing costs and benefits of new regulatory measures and their interactions

### Summary findings and policy implications
- Empirical studies point to importance of loss amplification by direct and indirect contagion and of including them in macroprudential stress tests.
- Loss contagion mechanisms do not distinguish between banks and non-banks, arguing for extending data collection and supervisory mechanisms to all financial institutions.
- Indirect contagion through fire sales can affect all financial institutions and lead to indirect exposures across banks mediated by other banks or non-banks.
- Communicating results of systemic stress tests to financial institutions in terms of their indirect exposures can help them internalize and manage systemic risk exposures.
- This requires data on institutional asset-class holdings, of the type used for bank stress tests.
- Capital adequacy criteria should incorporate a realistic assessment of systemic risk exposures.

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_Source: https://www.imf.org/-/media/files/news/seminars/mcm-lsecont_session3.pdf_