Fire Sales, Indirect Contagion and Systemic Stress Testing

50 Pages Posted: 30 Nov 2016 Last revised: 20 Jun 2017

See all articles by Rama Cont

Rama Cont

University of Oxford; CNRS

Eric Schaanning

Norges Bank; ETH Zurich, RiskLab, Department of Mathematics

Multiple version iconThere are 2 versions of this paper

Date Written: June 13, 2017

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

Suggested Citation

Cont, Rama and Schaanning, Eric, Fire Sales, Indirect Contagion and Systemic Stress Testing (June 13, 2017). Available at SSRN: https://ssrn.com/abstract=2541114 or http://dx.doi.org/10.2139/ssrn.2541114

Rama Cont (Contact Author)

University of Oxford ( email )

Mathematical Institute
Oxford, OX2 6GG
United Kingdom

HOME PAGE: http://https://www.maths.ox.ac.uk/people/rama.cont

CNRS ( email )

LPSM
Sorbonne University
Paris
France

HOME PAGE: http://rama.cont.perso.math.cnrs.fr/

Eric Schaanning

Norges Bank ( email )

P.O. Box 1179
Oslo, N-0107
Norway

ETH Zurich, RiskLab, Department of Mathematics ( email )

Ramistrasse 101
Zurich, 8092
Switzerland

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