We present a framework for modeling the phenomenon of fire sales in a network of financial institutions with common asset holdings, subject to leverage or capital constraints. Asset losses triggered by macro-shocks may interact with portfolio constraints, resulting in liquidation of assets, which in turn affects market prices, leading to contagion of losses when portfolios are marked to market. If mark-to-market losses are large, this may in turn lead to a new round of fire sales. In contrast to balance sheet contagion mechanisms based on direct linkages, this price-mediated contagion is transmitted through common asset holdings, which we quantify through liquidity-weighted overlaps across portfolios. Exposure to price-mediated contagion leads to the concept of indirect exposure to an asset class, as a consequence of which the risk of a portfolio depends on the matrix of asset holdings of other large and leveraged portfolios with similar assets.
Our model provides an operational systemic stress testing method for quantifying the exposure of the financial system to these effects.
Using data from the European Banking Authority, we apply this method to the examine the exposure of the EU banking system to price-mediated contagion.
Our results indicate that, even with optimistic estimates of market depth, moderately large macro-shocks may trigger fire sales which then lead to substantial losses across bank portfolios, modifying the outcome of bank stress tests. We propose a bank-level indicator, the Indirect Contagion Index, to quantify the contribution of a financial institution to price-mediated contagion.
R Cont, E Schaanning (2016) Measuring exposure to indirect contagion: the Indirect Contagion Index, Norges Bank Working Paper.