Leveraging the Network: A Stress-Test Framework Based on DebtRank

27 Pages Posted: 27 Feb 2015 Last revised: 23 Feb 2016

Stefano Battiston

University of Zurich - Department of Banking and Finance; Swiss Finance Institute

Guido Caldarelli

IMT Alti Studi Lucca

Marco D'Errico

University of Zurich; European Systemic Risk Board

Stefano Gurciullo

School of Public Policy, University College London

Date Written: February 22, 2016

Abstract

We develop a novel stress-test framework to monitor systemic risk in financial systems. The modular structure of the framework allows to accommodate for a variety of shock scenarios, methods to estimate interbank exposures and mechanisms of distress propagation. The main features are as follows. First, the framework allows to estimate and disentangle not only first-round effects (i.e. shock on external assets) and second-round effects (i.e. distress induced in the interbank network), but also third-round effects induced by possible fire sales. Second, it allows to monitor at the same time the impact of shocks on individual or groups of financial institutions as well as their vulnerability to shocks on counterparties or certain asset classes. Third, it includes estimates for loss distributions, thus combining network effects with familiar risk measures such as VaR and CVaR. Fourth, in order to perform robustness analyses and cope with incomplete data, the framework features a module for the generation of sets of networks of interbank exposures that are coherent with the total lending and borrowing of each bank. As an illustration, we carry out a stress--test exercise on a dataset of listed European banks over the years 2008-2013. We find that second-round and third-round effects dominate first-round effects, therefore suggesting that most current stress-test frameworks might lead to a severe underestimation of systemic risk.

Keywords: Systemic risk, financial networks, contagion, balance-sheets, stress-tests

Suggested Citation

Battiston, Stefano and Caldarelli, Guido and D'Errico, Marco and Gurciullo, Stefano, Leveraging the Network: A Stress-Test Framework Based on DebtRank (February 22, 2016). Available at SSRN: https://ssrn.com/abstract=2571218 or http://dx.doi.org/10.2139/ssrn.2571218

Stefano Battiston

University of Zurich - Department of Banking and Finance ( email )

Andreasstrasse 15
Z├╝rich, 8050
Switzerland

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Guido Caldarelli

IMT Alti Studi Lucca ( email )

Piazza San Francesco 19
Lucca, 55100
Italy

Marco D'Errico (Contact Author)

University of Zurich

Andreasstrasse 15
Zurich, 8050
Switzerland

European Systemic Risk Board ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Stefano Gurciullo

School of Public Policy, University College London ( email )

29/30 Tavistock Square
London, WC1H 9QU
United Kingdom

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