Monitoring Indirect Contagion

46 Pages Posted: 27 Jun 2018 Last revised: 8 Jun 2019

See all articles by Rama Cont

Rama Cont

University of Oxford

Eric Schaanning

European Systemic Risk Board - EUROPEAN SYSTEMIC RISK BOARD; Norges Bank

Date Written: March 2019

Abstract

We propose two indicators for quantifying the potential exposure of financial institutions to indirect contagion arising from deleveraging of assets in stress scenarios. The first indicator, the Endogenous Risk Index (ERI) captures spillovers across portfolios arising from deleveraging in stress scenarios. The second indicator, the Indirect Contagion Index (ICI) measures the systemic importance of a bank by quantifying the loss its distressed liquidation would inflict on other institutions. Both are computable from portfolio holdings of financial institutions and measures of market depth for the assets held in the portfolio. We discuss the micro-foundation of these indicators and apply them to the analysis of the vulnerability of the European banking system to indirect contagion.

Using data on portfolio holdings of European banks, we show that our indicators correlate to the magnitude of fire-sales losses in simulated stress scenarios, thus providing a simple to compute proxy for the outcome of stress tests. We also show that the information provided by our indicators on the systemic importance of banks is different from indicators based on size, thereby providing a measure of interconnectedness complementary to those currently used by supervisors.

Keywords: financial stability, price-mediated contagion, macro prudential regulation, systemic risk measurement

JEL Classification: C63, E58, G17, G18, G28

Suggested Citation

Cont, Rama and Schaanning, Eric, Monitoring Indirect Contagion (March 2019). Journal of Banking and Finance, Vol. 104, 2019, Available at SSRN: https://ssrn.com/abstract=3195174 or http://dx.doi.org/10.2139/ssrn.3195174

Rama Cont

University of Oxford ( email )

Mathematical Institute
Oxford, OX2 6GG
United Kingdom

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

Eric Schaanning (Contact Author)

European Systemic Risk Board - EUROPEAN SYSTEMIC RISK BOARD ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Norges Bank ( email )

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

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