A model of system-wide stress simulation: market-based finance and the Covid-19 event

Abstract

We build a model to simulate how the euro-area market-based financial system may function under stressed conditions, such as the COVID-19 turmoil. The core of the model is a set of representative agents reflecting key economic sectors, which interact in asset, funding and derivatives markets and face solvency and liquidity constraints on their behaviour. We illustrate the model’s behaviour with a two-layer approach. In Layer 1, we consider the deterioration in the outlook for the nonfinancial corporate sector. Agents reallocate their portfolios and risky asset prices fall. Layer 2 adds a rating downgrade shock to Layer 1, where a fraction of investment grade nonfinancial corporate bonds is downgraded to high yield. The additional shock creates further rebalancing pressure and price movements. For both layers we present asset flows (i.e. buying and selling marketable securities) across agents and balance sheet losses. The model provides quantitative support to the equilibrium effects of the macroprudential regulation of investment funds, which we illustrate by varying their liquidity buffers.

Keywords: systemic risk, market-based finance, stress testing, covid-19

JEL Classification: G17, G21, G22, G23