ECB on Simulating Fire Sales in a System of Banks and Asset Managers
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
Featured Experts
María Cañamero
Skilled market researcher; growth strategist; successful go-to-market campaign developer
Blake Coules
Across 35 years in banking, Blake has gained deep insights into the inner working of this sector. Over the last two decades, Blake has been an Operating Committee member, leading teams and executing strategies in Credit and Enterprise Risk as well as Line of Business. His focus over this time has been primarily Commercial/Corporate with particular emphasis on CRE. Blake has spent most of his career with large and mid-size banks. Blake joined Moody’s Analytics in 2021 after leading the transformation of the credit approval and reporting process at a $25 billion bank.
Nicolas Degruson
Works with financial institutions, regulatory experts, business analysts, product managers, and software engineers to drive regulatory solutions across the globe.
Previous Article
FASB Proposes Targeted Transition Relief for Credit Losses StandardNext Article
BCBS Updates Basel III Monitoring Workbook and FAQsRelated Articles
EBA Finalizes Templates for One-Off Climate Risk Scenario Analysis
The European Banking Authority (EBA) has published the final templates, and the associated guidance, for collecting climate-related data for the one-off Fit-for-55 climate risk scenario analysis.
EBA Mulls Inclusion of Environmental & Social Risks to Pillar 1 Rules
The European Banking Authority (EBA) recently published a report that recommends enhancements to the Pillar 1 framework, under the prudential rules, to capture environmental and social risks.
BCBS Consults on Disclosure of Crypto-Asset Exposures of Banks
As a follow on from its prudential standard on the treatment of crypto-asset exposures, the Basel Committee on Banking Supervision (BCBS) proposed disclosure requirements for crypto-asset exposures of banks.
BCBS and EBA Publish Results of Basel III Monitoring Exercise
The Basel Committee on Banking Supervision (BCBS) and the European Banking Authority (EBA) have published results of the Basel III monitoring exercise.
PRA Updates Timeline for Final Basel III Rules, Issues Other Updates
The Prudential Regulation Authority (PRA) recently issued a few regulatory updates for banks, with the updated Basel implementation timelines being the key among them.
US Treasury Sets Out Principles for Net-Zero Financing
The U.S. Department of the Treasury has recently set out the principles for net-zero financing and investment.
EC Launches Survey on G7 Principles on Generative AI
The European Commission (EC) launched a stakeholder survey on the draft International Guiding Principles for organizations developing advanced artificial intelligence (AI) systems.
ISSB Sustainability Standards Expected to Become Global Baseline
The finalization of the two sustainability disclosure standards—IFRS S1 and IFRS S2—is expected to be a significant step forward in the harmonization of sustainability disclosures worldwide.
IOSCO, BIS, and FSB to Intensify Focus on Decentralized Finance
Decentralized finance (DeFi) is expected to increase in prominence, finding traction in use cases such as lending, trading, and investing, without the intermediation of traditional financial institutions.
BCBS Assesses NSFR and Large Exposures Rules in US
The Basel Committee on Banking Supervision (BCBS) published reports that assessed the overall implementation of the net stable funding ratio (NSFR) and the large exposures rules in the U.S.
