Balance Sheet Interlinkages and Macro-Financial Risk Analysis in the Euro Area

48 Pages Posted: 11 Dec 2009

See all articles by Olli Castren

Olli Castren

European Central Bank (ECB)

Ilja Kristian Kavonius

European Central Bank; Centre for Consumer Society Research, University of Helsinki

Date Written: December 7, 2009

Abstract

The financial crisis has highlighted the need for models that can identify counter-party risk exposures and shock transmission processes at the systemic level. We use the euro area financial accounts (flow of funds) data to construct a sector-level network of bilateral balance sheet exposures and show how local shocks can propagate throughout the network and affect the balance sheets in other, even seemingly remote, parts of the financial system. We then use the contingent claims approach to extend this accounting-based network of interlinked exposures to risk-based balance sheets which are sensitive to changes in leverage and asset volatility. We conclude that the bilateral cross-sector exposures in the euro area financial system constitute important channels through which local risk exposures and balance sheet dislocations can be transmitted, with the financial intermediaries playing a key role in the processes. High financial leverage and high asset volatility are found to increase a sector’s vulnerability to shocks and contagion.

Keywords: Balance sheet contagion, financial accounts, network models, contingent claims analysis, systemic risk, macro-prudential analysis

JEL Classification: C22, E01, E21, E44, F36, G01, G12, G14

Suggested Citation

Castren, Olli and Kavonius, Ilja Kristian, Balance Sheet Interlinkages and Macro-Financial Risk Analysis in the Euro Area (December 7, 2009). ECB Working Paper No. 1124. Available at SSRN: https://ssrn.com/abstract=1516167

Olli Castren (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany
0049 69 13440 (Phone)
0044 69 1344 6000 (Fax)

Ilja Kristian Kavonius

European Central Bank ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany
+49-13448417 (Phone)

HOME PAGE: http://www.ecb.europa.eu/pub/research/authors/profiles/ilja-kristian-kavonius.en.html

Centre for Consumer Society Research, University of Helsinki ( email )

Finland

HOME PAGE: http://tuhat.helsinki.fi/portal/en/person/ikavoniu

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