Liquidity and Equity Short Term Fragility: Stress Tests for the European Banking System

Abstract

This paper assesses the resilience of Eurozone banks' equity and liquidity against large shocks to financial markets by using a CVRF model which combines copulas and factorial structures. Our analysis refers to 35 banks of the Eurozone from 2005 to 2015. Our contribution is threefold. First, we employ a model that takes into account not only the links between the assets composing banks' portfolios but we also consider second round and spillover effects between different markets and countries. We show that spillovers have notably changed over the sample period. Second, we measure the impact of different types of shocks (stock market and bond market) on bank's solvency and liquidity position and show that liquidity shortfalls are substantial, especially for banks from peripheral countries or domestic systemically important banks (D-SIB). Third, we assess the role of diversification in improving banks' resilience by examining the particular situation where stock and bond returns become positively dependent as recently observed. We show that for some banks it increases shortfalls up to 120%.

Keywords: Stress test, Financial Stability, Extreme Risks, Bank Balance Sheet, Systemic Risk, Copula, Risk factors

JEL Classification: F32, G17, G21