ECB published a working paper on simulating fire sales in a system of banks and asset managers. The authors developed an agent-based model of traditional banks and asset managers to investigate the contagion risk related to fire sales and balance-sheet interactions. In the paper, the authors explain the underlying theoretical model, the behavior of banks and asset managers, the equilibrium in the interbank lending market, the creation of the network of banks, the simulation of shocks, their propagation, and the dynamics of the system. The findings show that banks active in both the interbank and securities markets may channel financial distress between the two markets.
The key findings highlighted in the paper include the following:
- Requirements have an ample effect on the contagion spreading following a funding shock. Tighter liquidity regulation immunizes the system from liquidity shocks, but higher capital requirements make it more profitable to invest into less-liquid assets financed by interbank borrowing.
- The speed of contagion depends on which sector the initial shock hits first. Contagion instigated by an asset manager’s funding problem initially develops slowly but, as time evolves, it can have a higher impact than that for the initial shock affected a bank. Monitoring of the asset management sector activities is crucial to assess fire-sale risk.
- Fire sales are fueled by imbalances between demand and supply for securities. This is a clear externality of the fire sales that can be mitigated by the central banks providing liquidity to the system.
- Asset managers absorb small liquidity shocks, but they exacerbate contagion when their voluntary liquid buffers are fully utilized.
- Business models of banks, their heterogeneity in sizes, and interconnectedness matter for the magnitude of losses under funding stress conditions.
Future work on more granular balance sheets of banks and asset managers may be needed to empirically analyze the two identified trade-offs. First, higher capital requirements may increase the resilience of the entire system by strengthening the capital position of individual banks. However, they may enhance contagion by homogenizing banks’ balance sheets. Second, while non-regulated asset managers may exacerbate contagion and fire sales, they can also provide flexible buffers and absorb the adverse effects of small liquidity shocks.
Related Link: Paper (PDF)
Keywords: Europe, EU, Banking, Securities, Fire Sales, Contagion Risk, Systemic Risk, Capital Requirement, Asset Management, Liquidity Risk, ECB
Previous ArticleCBK Publishes Cybersecurity Framework for Banking Sector in Kuwait
BIS published the September issue of the Quarterly Review, which contains special features that analyze the rapid rise in equity funding for financial technology firms, the effectiveness of policy measures in response to pandemic, and the evolution of international banking.
The Basel Committee for Banking Supervision (BCBS) met in September 2021 and reviewed climate-related financial risks, discussed impact of digitalization, and welcomed efforts by the International Financial Reporting Standards (IFRS) Foundation to develop a common set of sustainability reporting standards
The Office of the Comptroller of the Currency (OCC) issued a Cease and Desist Order against MUFG Union Bank for deficiencies in technology and operational risk governance.
The European Commission (EC) published the Delegated Regulation 2021/1527 with regard to the regulatory technical standards for the contractual recognition of write down and conversion powers.
In a response to the questions posed by a member of the European Parliament, the President Christine Lagarde highlighted the commitment of the European Central Bank (ECB) to an ambitious climate-related action plan along with a roadmap, which was published in July 2021.
The Single Resolution Board (SRB) published a Communication on the application of regulatory technical standard provisions on prior permission for reducing eligible liabilities instruments as of January 01, 2022.
The Australian Prudential Regulation Authority (APRA) published a new set of frequently asked questions (FAQs) to provide guidance to authorized deposit-taking institutions on the interpretation of APS 120, the prudential standard on securitization.
The French Prudential Control and Resolution Authority (ACPR) published the corrective version of the RUBA taxonomy Version 1.0.1, which will come into force from the decree of January 31, 2022.
The European Commission (EC) announced that Nordea Bank has signed a guarantee agreement with the European Investment Bank (EIB) Group to support the sustainable transformation of businesses in the Nordics.
The Australian Prudential Regulation Authority (APRA) published a new set of frequently asked questions (FAQs) to clarify the regulatory capital treatment of investments in the overseas deposit-taking and insurance subsidiaries.