Rama Cont, University of Oxford: Endogenous risk, indirect contagion and systemic risk

Deleveraging by financial institutions in response to losses may lead to contagion of losses across institutions with common asset holdings. Unlike direct contagion via counterparty exposures, this channel of contagion -which we call indirect contagion- is mediated through market prices and does not require bilateral exposures or relations. We show nevertheless that indirect contagion in the financial system may be modeled as a contagion process on an auxiliary network defined in terms of 'liquidity weighted portfolio overlaps' and we study various properties of this network using data from EU banks. Exposure to price-mediated contagion leads to the concept of indirect exposure to an asset class, as a consequence of which the risk exposure of a portfolio strongly depends on the asset holdings of large institutions in the network. We propose a systemic stress testing methodology for evaluating this risk exposure and construct a simple indicator of bank-level exposure to indirect contagion – the Indirect Contagion Index – based on the analysis of liquidity-weighted overlaps across bank portfolios. This indicator is shown to be strongly correlated with bank losses due to deleveraging and may be used to quantify the contribution of a financial institution to price-mediated contagion.

Joint work with  Eric Schaanning (European Systemic Risk Board).

References:

[1] Rama Cont, Eric F Schaanning (2016) Fire Sales, Indirect Contagion and Systemic Stress Testing. https://ssrn.com/abstract=2541114

[2] Rama Cont, Eric F Schaanning (2017) Monitoring Indirect Contagion.  https://ssrn.com/abstract=3195174