On the Origin of Systemic Risk

49 Pages Posted: 3 Feb 2021

See all articles by Mattia Montagna

Mattia Montagna

European Central Bank (ECB)

Gabriele Torri

University of Bergamo

Giovanni Covi

Bank of England

Multiple version iconThere are 3 versions of this paper

Date Written: January 29, 2021

Abstract

Systemic risk in the banking sector is usually associated with long periods of economic downturn and very large social costs. On one hand, shocks coming from correlated exposures towards the real economy may induce correlation in banks’ default probabilities thereby increasing the likelihood for systemic tail events like the 2008 Great Financial Crisis. On the other hand, financial contagion also plays an important role in generating large-scale market failures, amplifying the initial shocks coming from the real economy. To study the sources of these rare phenomena, we propose a new definition of systemic risk (ie the probability of a large number of banks going into distress simultaneously) and thus we develop a multilayer microstructural model to study empirically the determinants of systemic risk. The model is then calibrated on the most comprehensive granular dataset for the euro-area banking sector, capturing roughly 96% or €23.2 trillion of euro-area banks’ total assets over the period 2014–2018. The outputs of the model decompose and quantify the sources of systemic risk showing that correlated economic shocks, financial contagion mechanisms, and their interaction are the main sources of systemic events. The results obtained with the simulation engine resemble common market-based systemic risk indicators and empirically corroborate findings from existing literature. This framework gives regulators and central bankers a tool to study systemic risk and its developments, pointing out that systemic events and banks’ idiosyncratic defaults have different drivers, hence implying different policy responses.

Keywords: Systemic risk, financial contagion, microstructural models

JEL Classification: D85, G17, G33, L14

Suggested Citation

Montagna, Mattia and Torri, Gabriele and Covi, Giovanni, On the Origin of Systemic Risk (January 29, 2021). Bank of England Working Paper No. 906, Available at SSRN: https://ssrn.com/abstract=3778199 or http://dx.doi.org/10.2139/ssrn.3778199

Mattia Montagna (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Gabriele Torri

University of Bergamo ( email )

Salvecchio 19
Bergamo, 24129
Italy

Giovanni Covi

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

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