Featured Product

    ECB Paper on Interconnected Banks and Systemically Important Exposures

    November 20, 2019

    ECB published a working paper that studies systemic risk arising from direct interbank contagion effects and from indirect contagion through portfolio overlaps across economic sectors. A strongly non-linear relationship has been identified between diversification of exposures, shock size, and losses due to interbank contagion. Moreover, the most systemically important sectors tend to be the households and the financial sectors of larger countries because of their size and position in the financial network.

    The paper studies the interplay between two channels of interconnectedness in the banking system. The first one is a direct interconnectedness, via a network of interbank loans, banks’ loans to other corporate and retail clients, and securities holdings. The second channel is an indirect interconnectedness, via exposures to common asset classes. To this end, the authors analyzed unique supervisory data set collected by ECB that covers 26 large banks in the euro area. To assess the impact of contagion, the authors applied Network Valuation or NEVA model, in which common shocks to banks’ external assets are reflected in a consistent way in the market value of banks’ mutual liabilities through the network of obligations. Finally, the authors provide policy insights into the potential impact of more diversified versus more domestic portfolio allocation strategies on the propagation of contagion, which are relevant to the policy discussion on the European Capital Markets Union.

    The key findings can be summarized as follows:

    • The authors found a substantial portfolio overlap on banks’ exposures to the financial sector. 
    • Measuring the impact of an exogenous shock by the number of defaults allows us to empirically support the theoretical results that more diversified interlinkages mitigate contagion risk for small perturbations in the system but may lead to higher contagion for larger shocks. Specifically, it has been found that an internationally diversified network of exposures is more resilient than a more domestic one for small shocks but less resilient for large shocks.
    • The role of the financial network architecture for risk mitigation or amplification is ambiguous. Some configurations of financial contracts seem to increase financial stability. However, this happens at a cost for external creditors of the banks who would cover losses not absorbed by the banking system.
    • Under a stress scenario of EBA designed for the 2016 EU-wide stress-test exercise first and second round contagion losses are comparable in size, although there is some heterogeneity across banks. In other words, the financial contagion channel—which tends to be ignored in supervisory stress tests—may have a non-negligible impact on banks’ solvency.
    • The measure of the leverage overlap is highly correlated with the outcomes of the fully-fledged contagion analysis based on the NEVA methodology. Therefore, the authors derived a lower bound for losses based on leverage overlap which is an accurate indicator of systemic risk stemming from overlapping portfolios of banks.

    These findings have important policy implications. First, when assessing risks from interconnectedness only focusing on direct intra-financial assets and liabilities, while ignoring more indirect contagion channels (such as common exposures) and underestimating the true contagion potential of systemic institutions. Second, there is value added to conducting macro-prudential stress tests incorporating contagion spillovers due to interconnectedness to complement findings of banking sector resilience drawn from traditional supervisory stress tests. Third, there is not one optimal network structure and there is a clear trade-off between financial diversification and the size of shocks hitting the system.

     

    Related Link: Working Paper (PDF)

     

    Keywords: Europe, EU, Banking, Systemic Risk, Stress Testing, Interbank Contagion, Capital Markets Union, NEVA Model, Contagion Risk, EBA, ECB

    Featured Experts
    Related Articles
    News

    APRA Decides to Standardize Submission Date for Quarterly Reporting

    APRA announced the standardization of quarterly reporting due dates for authorized deposit-taking institutions.

    May 11, 2021 WebPage Regulatory News
    News

    Bundesbank Publishes Supporting Documentation for Reporting by Banks

    Bundesbank published a list of "EntryPoints" that are accepted in its reporting system; the list provides taxonomy version and name of the module against each EntryPoint.

    May 11, 2021 WebPage Regulatory News
    News

    ECB Working Group Publishes Recommendations on EURIBOR Fallbacks

    The private sector working group of ECB on euro risk-free rates published the recommendations to address events that would trigger fallbacks in the Euro Interbank Offered Rate (EURIBOR)-related contracts, along with the €STR-based EURIBOR fallback rates (rates that could be used if a fallback is triggered).

    May 11, 2021 WebPage Regulatory News
    News

    EBA Publishes Phase 1 of Reporting Framework 3.1

    EBA published the phase 1 of its reporting framework 3.1, with the technical package covering the new reporting requirements for investment firms (under the implementing technical standards on investment firms reporting).

    May 10, 2021 WebPage Regulatory News
    News

    APRA to Finalize Capital Adequacy Standard Revisions by January 2022

    Asia Pacific Australia Banking APS 111 Capital Adequacy Regulatory Capital Basel RBNZ APRA

    May 10, 2021 WebPage Regulatory News
    News

    ESMA Issues Guidelines on Outsourcing to Cloud Service Providers

    ESMA published the final guidelines on outsourcing to cloud service providers.

    May 10, 2021 WebPage Regulatory News
    News

    EBA Publishes Data on Deposit Guarantee Schemes

    EBA published annual data for two key concepts and indicators in the Deposit Guarantee Schemes (DGS) Directive—available financial means and covered deposits.

    May 10, 2021 WebPage Regulatory News
    News

    OSFI Sets Out Plan for Future Guidance on Managing Technology Risk

    OSFI has set out the schedule for release of draft guidance on the management of technology risks by federally regulated financial institutions and private pension plans.

    May 10, 2021 WebPage Regulatory News
    News

    MAS Updates Housing Loan Rules, Proposes Corporate Governance Guidance

    MAS updated rules for new housing loans by banks and finance companies.

    May 10, 2021 WebPage Regulatory News
    News

    HKMA Publishes Guideline on Sustainable Finance Grant Scheme

    HKMA published a statement on the 100% Personal Loan Guarantee Scheme and a guideline on the Green and Sustainable Finance Grant Scheme (GSF Grant Scheme) as announced in the 2021-22 Budget.

    May 09, 2021 WebPage Regulatory News
    RESULTS 1 - 10 OF 6959