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
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.
Previous ArticleCBK Publishes Cybersecurity Framework for Banking Sector in Kuwait
The European Commission (EC) published the Delegated Regulation 2022/786 with regard to the liquidity coverage requirements for credit institutions under the Capital Requirements Regulation (CRR).
The European Banking Authority (EBA) published the final draft regulatory technical standards specifying the criteria to identify shadow banking entities for the purposes of reporting large exposures.
The European Insurance and Occupational Pensions Authority (EIOPA) published a report assessing insurers' exposure to physical climate change risks
The European Commission (EC) published the results of a public consultation, held in October 2021, on the review of the Web Accessibility Directive.
The Network for Greening the Financial System (NGFS) published two reports to aid central banks and regulators in their oversight of the financial sector and in their central bank operations
The Monetary Authority of Singapore (MAS) and the SC-STS are jointly consulting, until June 10, 2022, on setting adjustment spreads for the conversion of legacy SOR contracts to SORA reference rate.
The Office of the Superintendent of Financial Institutions (OSFI) published the strategic plan for 2022-2025 and the departmental plan for 2022-23.
The European Banking Authority (EBA) is consulting, until August 31, 2022, on the draft implementing technical standards specifying requirements for the information that sellers of non-performing loans (NPLs) shall provide to prospective buyers.
The European Council and the Parliament reached an agreement on the revised Directive on security of network and information systems (NIS2 Directive).
The European Banking Authority (EBA) published the final draft regulatory technical standards specifying information that crowdfunding service providers shall provide to investors on the calculation of credit scores and prices of crowdfunding offers.