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.
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