This paper studies how the Greek sovereign credit event in March 2012 impacted the credit default swap (CDS) market from market-wide and investor behaviour perspectives, using both network tools to a dataset of snapshots of the global bilateral CDS exposures and a panel analysis on CDS spreads. Regarding the CDS spreads, we find very little discernible direct impact of the Greek credit event on CDS spreads overall. This finding provides some further evidence that the Greek credit event was well anticipated by most market participants. However, we find several significant changes in the Greek CDS network structure following the credit event: the number of connections via exposures declined significantly, the directionality of the positions (net long vs net short) of the main groups of market participants reversed, while none of the non-banks returned to trade Greek CDSs until the last observation of dataset (October 2014). Regarding indirect effects to other CDS markets, we find evidence of temporary spill-over effects on CDS reference entities with credit risk associated with the risk of the Greek sovereign. In particular, the market and counterparty structures changed temporarily with all types of traders decreasing their exposures to the EU periphery sovereign reference entities and also changing their trading counterparties, while after some time, the structure of the market returned to a similar one observed before the credit event. Finally, we find some support for the bank-sovereign nexus, as there was a consistent retreat from the CDS exposures on banks in the EU periphery countries, contrary to banks residing in the other EU countries.

We evaluate the impact of contagion and common exposures on banks’ capital using a structural regression framework derived from the balance sheet identity and inspired by the structural VAR literature. Contagion arises through bilateral exposures, fire sales, rollover risk, and market-based sentiment, while common exposures reflect overlapping portfolio holdings. We estimate the model using granular regulatory balance sheet and interbank exposure data for the Canadian banking sector. Our results yield three key insights. First, contagion driven by bilateral contractual exposures remains relatively stable over time until the onset of quantitative easing. In contrast, non-contractual contagion channels are less stable and move with market conditions. Second, we observe an increase in common exposure risk along with a decrease in contagion risk, following unprecedented fiscal and monetary policy measures in the COVID-19 pandemic. Third, we demonstrate how our framework complements traditional bank stress-testing approaches that focus on individual institutions by analysing second-round effects. In a policy application, we simulate targeted bailouts and show that their effectiveness in stabilizing the system is related to the interconnectedness of the rescued institution.

In this cover paper, we introduce a Special Issue (SI) published after the fourth edition of a series of financial stability conferences organized by Bank of Mexico, CEMLA, Bank of Canada, Zurich University and the Journal of Financial Stability in November 2021. Before providing our perspective on why the research papers included into the SI are of great relevance, we give a brief and personal overview of recent directions in financial stability research in general, esp., related to topics accentuated by the COVID-19 pandemic or post-pandemic economic and financial conditions and their complexity. Papers published in the SI cover four topics of research in the financial stability field, featuring some outstanding and innovative projects presented during the conference. The first topic is on interconnectedness and shock transmission in the financial system, diving deep into asset fire sales, interconnectedness of various segments of the financial system, in addition to banks, on the optimality of systemic risk capital buffers, and on how risks are priced in the interbank market network. The second one touches upon climate change risks looking at investors’ reactions to international climate policy developments, in particular on the Paris Agreement front and how to jointly model physical and transition risk in the banking system, including the important concept of double materiality. The third topic is represented by projects focused on policy analysis for systemic risk mitigation, specifically dealing with macroprudential policy instruments and crisis mitigation policies. Finally, research papers in the last topic on big data and market data focus on the innovative ways to explore the growing body of data sources, such as data collected by regulators, including credit register data, supervisory data and market data on financial transactions, to better understand sources and implications of systemic risk.

We develop an agent-based model of traditional banks and asset managers to investigate the contagion risk related to fire sales and balance sheet interactions. We take a structural approach to the price formation in fire sales as in Bluhm et al. (2014) and introduce a market clearing mechanism with endogenous formation of asset prices. We find that, first, banks which are active in both the interbank and securities markets act as plague-spreaders during financial distress. Second, higher bank capital requirements may aggravate contagion by creating incentives for banks to increase exposures in the interbank market, which also leads to lower levels of a voluntary capital buffer above the minimum capital requirement. Third, asset managers absorb small liquidity shocks, but they exacerbate contagion when their voluntary liquid buffers are fully utilised. Fourth, a system with larger and more interconnected agents is more prone to contagion risk stemming from funding shocks.

One of the most important elements of the post-crisis financial reforms was to establish credible resolution frameworks allowing for creditor bail-in when banks are entering resolution. Despite the obvious benefits of shifting the burden of resolution from taxpayers to bank creditors, bank bail-ins may also give rise to costs as the financial consequences for bank shareholders and creditors being bailed in could endanger their own financial situation and potentially entail systemic implications. Using granular data on the securities cross-holdings among the largest euro area banking groups, we construct a multi-layered network model where each layer represents bail-inable securities of a specific seniority layer of the creditor hierarchy. The model can be a useful tool for resolution authorities to inform the policy discussion on both the composition and level of loss absorbing capacity of banks and the direct contagion risk following a bail-in. We find that due to low levels of securities cross-holdings in the interbank network there is no direct contagion in terms of creditor banks failing as a result of another bank being bailed in. At the same time, we document that a bail-in will have pecuniary consequences on the different liability holders and our framework allows for an exact quantification of those effects. In addition, we show that recapitalisations following a bail-in will change the network structure and hence the embedded contagion risk.

Capturing financial network linkages and contagion in stress test models are important goals for banking supervisors and central banks responsible for micro- and macroprudential policy. However, granular data on financial networks is often lacking, and instead the networks must be reconstructed from partial data. In this paper, we conduct a horse race of network reconstruction methods using network data obtained from 25 different markets spanning 13 jurisdictions. Our contribution is two-fold: first, we collate and analyze data on a wide range of financial networks. And second, we rank the methods in terms of their ability to reconstruct the structures of links and exposures in networks.