Measuring Capital at Risk with Financial Contagion: Two-Sector Model with Banks and Insurers

54 Pages Posted: 21 Aug 2024

Abstract

How do interdependent economic shocks impact the financial system and reverberate within it? To model the financial system, we start with a two-sector microstructural model of the financial system that includes banks and insurers. We develop a stress testing methodology that stochastically computes economic profits and losses at banks and insurers following correlated corporate default shocks. Taking into account the feedback and amplification of the initial shock though the financial system, we quantify its impact on firms’ capital positions. This methodology is applied to a very rich panel data set of UK banks and insurers. Our approach enables us to distil the contribution of initial economic shocks and the feedback and amplification mechanisms to extreme tail events. Overall, we find that, since the Covid-19 Pandemic (2020-21), the UK financial system has experienced an improvement in both profit expectations and tail losses. Comparing sectoral losses in an extreme stress scenario, we find that insurers are more affected than banks by economic credit and traded risk losses, while fire sale losses affect banks more than insurers.

Keywords: Credit Risk Portfolio, Systemic Risk, Financial Contagion, Financial Network, System-wide Stress Testing

Suggested Citation

Covi, Giovanni and Hüser, Anne-Caroline, Measuring Capital at Risk with Financial Contagion: Two-Sector Model with Banks and Insurers. Available at SSRN: https://ssrn.com/abstract=4932588 or http://dx.doi.org/10.2139/ssrn.4932588

Giovanni Covi

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

Anne-Caroline Hüser (Contact Author)

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

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