Fire Sales, Indirect Contagion and Systemic Stress Testing

Abstract

We present an operational framework for quantifying the impact of deleveraging in stress scenarios by financial institutions subject to portfolio constraints. Market impact of portfolio deleveraging in stress scenarios leads to price-mediated contagion across institutions with similar holdings. We show that this loss contagion may be quantified through "liquidity-weighted overlaps" across portfolios and leads to indirect exposures to asset classes.

Using data on European banks, we show that such indirect contagion effects may modify the outcome of bank stress tests and lead to heterogeneous bank-level losses which cannot be replicated in a stress test without deleveraging effects.

Our methodology distinguishes insolvency from illiquidity and leads to substantially different loss estimates compared to models based on `leverage targeting'.

Keywords: systemic risk, fire sales, financial stability, contagion, macroprudential regulation, financial regulation, capital adequacy, stress testing

JEL Classification: G01, G28, G32