Ebook Balance Sheet Interlinkages And Macro-Financial Risk Analysis In The Euro Area
The process of financial stability assessment typically involves identification of risks and vulnerabilities in various parts of the financial system. It also calls for identification of potential triggering events which, if crystallised, could flip the state of the financial system from stability to instability. But the events of the recent global financial turmoil have demonstrated that financial stability analysis should, perhaps first and foremost, also aim at identifying links between sectors and channels through which local shocks may propagate wider in the financial system. Seeing the financial system as a network of interlinked exposures can help to detect such transmission mechanisms. Analysis of this network may then reveal that parts of the financial system that might not be considered particularly vulnerable to a given adverse scenario could still be affected due to their close interconnection with sectors that are directly confronted by the unforeseen events.
This paper proposes a new framework for analysing financial system stability that captures several types of interlinkages within the financial system. The approach yields three main contributions to the existing work: first, by using the flow of funds data from the euro area financial accounts and thus focusing on sector-level bilateral exposures, we aim at filling a gap in the literature that applies networks to financial stability analysis. The existing studies mainly look at bilateral exposures at the firm-level, such as in the interbank money markets, or at the country level, typically using cross-border banking flows data. Second, in the latter part of the paper, we apply the contingent claims analysis to extend the constructed accounting-based network of bilateral exposures to a risk-based network where we can trace also the propagation of volatility shocks and changes in risk exposures. This extension provides particularly interesting results as regards the interactions between leverage and volatility in an environment where measures of credit risk are characterised by strong non linearities. Third, we carry out simulation exercises which illustrate the extent of balance sheet contagion (defined as propagation of mark-to-market losses along the bilateral exposures) and risk contagion (defined as an increase in correlation among sector-level risk exposures in times of financial stress) in the euro area financial system.
The main results of our work can be summarised as follows. Over the first ten years of the EMU, the bilateral financial accounts network linkages have grown markedly, with the banking sector constituting a key part of the euro area financial system. In simulation exercises we analyse the propagation of shocks and contagion in the network of sector-level balance sheets in a multi-period context and find that under mark-to-market accounting, localcash-flow shocks can spread around quickly along the bilateral exposures even when there are no defaults in the process, with banks and non-financial firms playing key roles in the transmission. These results provide interesting empirical support to the conceptual models of shock transmission via balance sheet exposures as formalised, among others, by Kiyotaki and Moore (1997, 2002), Goodhart (2006) and Shin (2008). We then calculate the risk-based balance sheets for individual sectors following the recent conceptual work by Gray, Merton and Bodie (2007) and Gary and Malone (2008). Simulation exercises on the risk-based network illustrate how correlations among sector-level risk indicators surged amid the outbreak of the financial turmoil in mid-2007. We also show how sector-level credit risk indicators are affected by shocks in other parts of the network and how the risk indicators of sectors with highest leverage are the most vulnerable ones to shocks to volatility. In that sense, higher leverage increases sensitivity to volatility shocks in the same way as in deeply out-of-the money options.
In a recent paper, Borio and Drehmann (2009) argue that the desirable features of an operational financial stability framework should include, inter alia, the following three characteristics. First, it should focus on the financial system as a whole as opposed to individual institutions. Second, the more interconnected areas of the system should deserve more attention than others. Third, the analysis should capture common exposures, arising either from claims to non-financial sectors or from exposures within the financial sector. Our proposed framework captures these features and it thus provides one contribution to the work towards such operational frameworks. It also opens up several avenues for further research in financial stability and macro prudential analysis using network models and risk-based balance sheets.
The rest of this paper proceeds as follows. Section 2 describes the balance sheet data and discusses the pros and cons of using financial accounts data in the context of financial stability analysis. In section 3 we calculate the network of bilateral balance sheet exposures. Section 4 analyses the transmission of shocks in the accounting-based network. Section 5 contains the analysis of risk-based balance sheets. Section 6 concludes.
CONTENTS
Abstract
Executive Summary
1 Introduction
2 Description of the balance sheet data
3 The network of balance sheet exposures for the euro area financial system
4 Transmission of shocks in the network of balance sheet exposures
5 Measuring systemic risk using risk-based balance sheets
- 5.1 The sector-level contingent claims model
5.2 Estimation of sector-level risk indicators
5.3 Shocks in the risk-based network of bilateral exposures
6 Concluding remarks
References
Annexes
European Central Bank Working Paper Series
Download
PDF Ebook Balance Sheet Interlinkages And Macro-Financial Risk Analysis In The Euro Area
Posted in :
