In this paper we present a methodology of model-based calibration of additional capital needed in an interconnected financial system to minimize potential contagion losses. Building on ideas from combinatorial optimization tailored to controlling contagion in case of complete information about an interbank network, we augment the model with three plausible types of fire sale mechanisms. We then demonstrate the power of the methodology on the euro area banking system based on a network of 373 banks. On the basis of an exogenous shock leading to defaults of some banks in the network, we find that the contagion losses and the policy authority’s ability to control them depend on the assumed fire sale mechanism and the fiscal budget constraint that may or may not restrain the policy authorities from infusing money to halt the contagion. The modelling framework could be used both as a crisis management tool to help inform decisions on capital/liquidity infusions in the context of resolutions and precautionary recapitalizations or as a crisis prevention tool to help calibrate capital buffer requirements to address systemic risks due to interconnectedness.

This paper shows how the combined endogenous reaction of banks and investment funds to an exogenous shock can amplify or dampen losses to the financial system compared to results from single-sector stress testing models. We build a new model of contagion propagation using a very large and granular data set for the euro area. Based on the economic shock caused by the Covid-19 outbreak, we model three sources of exogenous shocks: a default shock, a market shock and a redemption shock. Our contagion mechanism operates through a dual channel of liquidity and solvency risk. Our analysis reveals that adding the fund sector to our model for banks leads to additional losses through fire sales and a further depletion of banks’ capital ratios by around one percentage point. The main driver of additional bank losses are endogenous market losses generated by investment funds’ asset liquidation.