Knowledge that Transforms

We study how the practice of collateral rehypothecation impacts the generation of liquidity and the emergence of systemic liquidity risk, and how both depend on the structure of the financial network. We build a basic model where banks interact via chains of “repo” contracts (i.e. repurchasing agreements) and use their proprietary collateral or re-use the collateral obtained by other banks via “reverse repos”. We then extend the model to allow banks to determine endogenously the optimal amount of collateral to rehypothecate, based on the equilibrium level of Value-at-Risk. In this framework, we first show how total collateral volume and its velocity are affected by characteristics of the network such as the length of rehypothecation chains and the existence of closed (i.e. cyclic) chains of contracts, the presence of sink nodes (wherein collateral remains trapped), the direction of collateral flows, and the density of the network. We then demonstrate that a trade-off between liquidity and systemic risk exists for certain classes of networks structures. On the one hand, we show that structures where collateral flows are concentrated among fewer densely connected nodes allow for larger collateral volumes, even at low levels of network density. On the other hand, the same networks are also more exposed to larger cascades of collateral hoarding, as a result of localized liquidity shocks.

We simulate the impact on the nonbank liabilities of banks in a multiplex interbank environment arising from changes in currency exposure. Currency shocks as a source of financial contagion in the banking sector have not, so far, been considered. Our model considers two sources of contagion: shocks to nonbank assets and exchange rate shocks. Interbank loans can mature at different times. We demonstrate that a dominant currency can be a significant source of financial contagion. We also find evidence of asymmetries in losses stemming from large currency depreciations versus appreciations. A variety of scenarios are considered allowing for differences in the sparsity of the banking network, the relative size and number of banks, changes in nonbank assets and equity, the possibility of bank breakups, and the dominance of a particular currency. Policy implications are also drawn.

This study aims to investigate the impact of a wide range of economic and non-economic events on stock market spillover effects in a group of 16 major developed and emerging countries over the 2000–2020 period. We analyse the size and structure of contagion to verify how different events spread contagion across borders and sectors. We applied the methodology proposed by Diebold and Yilmaz (2009, 2012, 2014) to a wide range of stock market indices using a quantile regression framework. Our findings show that the sectoral and country-specific indices usually range below the overall market contagion levels, while their density functions differ structurally from those of overall market contagion. Among non-economic events, viruses – notably, the COVID-19 pandemic – are the most widespread sources of contagion, while terrorism events affect the widest range of sectors with the greatest magnitude. Among economic events, the strongest negative impact is found for prudential ones. Quantitative easing (QE) and liquidity support reduce overall market contagion, while QE unwinding has a more substantial role than its introduction or expansion, exemplifying its asymmetric impact. We also investigate how investors may benefit from using contagion information in developing trading strategies, highlighting the positive impact of spillover-based weightings on portfolio returns.

Using a novel cross-European dataset on bank internationalization, the paper accounts for organizational and geographic complexity and evaluates its impact on systemic risk and how both the 2008–09 global financial crisis and the 2010–11 European sovereign debt crisis might have modified such an impact. Ahead of the crisis (2005–07), results suggest that bank complexity materially reduces systemic risk and enhances stability, as it encourages banks to take on more diversified risks. While such a relation is inverted during the crisis (2008–11) and after the crisis (2012–13), consistent with the view that, during distress times, international banks have less ability to monitor cross-border risks. Further evidence show that, regardless of the period, the effect of complexity on systemic risk is accentuated for ‘too-big-too-fail’ banks and banks with strong activity diversity. Conversely, complex banks with merger-acquisition history and banks operating networks of foreign branches mitigate systemic risk during the acute crisis and the later stage of the crisis, respectively. The results are robust to the use of alternative measures of systemic risk and complexity, and numerous additional tests. Findings bear critical policy implications for financial regulations.

Is the asset management sector a source of financial instability? This paper develops a macroprudential stress test model which enables the quantification of systemic vulnerabilities due to fire sales in this sector. The model incorporates the flow-performance relationship as an additional funding shock in the model of Greenwood et al. (2015). Using data on US equity mutual funds for the period 2003–14, we quantify both fund-specific and system-wide (aggregate) vulnerabilities to fire sales over time. Our main finding is that the aggregate vulnerability, according to this propagation mechanism, is relatively small in comparison with values reported for banks. However, during periods of low market liquidity, the vulnerability of the system can become significant. Our paper also contributes to the ongoing discussion on the SIFI designation of Non-Bank Non-Insurer entities. For this purpose, we explore the determinants of individual funds’ vulnerability to systemic asset liquidations, highlighting the importance of size and portfolio illiquidity. Therefore, regulators should monitor structural vulnerabilities in the fund sector arising through liquidity transformation.

Recent financial crises have prompted the interest in understanding how banking globalization interacts with domestic institutions in shaping foreign shocks’ transmission. This paper uses regional banking data from Brazil to show that a foreign funding shock to banks negatively affects lending by their regional branches. This effect increases in the presence of frictions in internal capital markets, which affect branches’ capacity to access funding from other regions via intra-bank linkages. These results also matter on an aggregate level, as municipality-level credit and job flows drop in exposed regions. Policies aiming to reduce the fragmented structure of regional banking markets could moderate the propagation of foreign shocks.

We provide a new metric for the systemic importance of banks based on the intensity of spillovers of daily CDS movements. We denote this a bank’s Individual Systemic Risk (ISR). Our novel empirical tool uses Bayesian VAR to address the dimensionality problem in large networks of banks and maps for every pair of banks in the system the shocks that they exchange. We apply this tool to all banks that issue publicly traded CDS contracts among the world’s biggest 150 and identify which of these may trigger instability in the global financial system. Our methodology provides measures that are relatively stable across time, contain persistent information, have strong explanatory power for standard variables of systemic risk, and provided early warning signals in the case study of Deutsche Bank in mid-2016. Using our ISR measure, we demonstrate which bank- and country-specific characteristics are related to bank systemic importance. We find higher systemic importance for banks that are relatively larger, less profitable, have G-SIB status, and are headquartered in economies with fiscally strong sovereigns. We also show that there is a negative relationship between concentration in the domestic banking sector and the systemic importance of a bank. We examine the relationship of ISR to alternative systemic risk metrics.

We study the timing of the European Corporate Sector Purchase Program and its direct effect on corporate financing decisions. Consistent with the goal of reducing credit premia, more timely purchases are observed for eligible bonds characterized by higher credit risk. Firms effectively targeted increase their relative use of market debt and the maturity of newly issued bonds more than eligible but not (yet) targeted issuers. The estimated effect is not driven by the verified relation between selection and credit risk. The program has fostered the ability to tap credit markets directly especially for eligible corporations whose bonds are actually purchased.

We estimate the causal effect of natural catastrophes on financial depth. We focus on largest catastrophes in 1960–2016, employ synthetic control method to compute the counterfactual and use the private credit to GDP ratio as the measure of financial deepening. Our estimates show that the effects of natural catastrophes are sizable, statistically significant and long-lasting. We find that a decade after the catastrophe, credit/GDP ratio remains approximately 30% below its counterfactual. This result suggests that large-scale natural catastrophes severely undermine financial deepening in developing economies.

We examine the impact of bank liquidity creation on systemic risk and its heterogeneous impact over the network connectedness. We find that excessive liquidity creation increases the systemic risk with a “U shape” relationship, while internal and external liquidity creation drives systemic risk in a different way. Network connectedness of banks strengthens the relationship between liquidity creation and systemic risk. Our results provide supporting evidence on regulating bank liquidity creation to enhance the financial stability.