Fire-sale externalities in the Euro-area banking system
The mechanics through which such spill-overs occur can be described as follows. As documented by several studies, financial firms often target leverage. When a bank experiences an adverse shock to its equity capital which increases its leverage, one way to return to the target leverage is to shed assets and pay off debt. At times when market liquidity is scarce or an asset is illiquid, a financial institution which is forced to liquidate that asset can depress its price. As a consequence, other financial institutions holding the same asset (or the same asset class) will suffer a loss, even if they do not have direct linkages with the firms initiating the (fire) sale. Affected financial institutions may sell other assets to shore up their balance sheets. Therefore, common asset exposures result in contagion, which occurs through seemingly unrelated assets and banks.
By employing granular balance sheet data on commercial banks, the goal of this study is to provide an aggregate vulnerability (AV) indicator for euro area banks based on the framework developed by Greenwood, Landier and Thesmar (GLT,forthcoming). This indicator measures how much equity capital in the banking system is wiped out after a shock and liquidation spirals occur.
Furthermore, the project extends the framework proposed by GLT. In particular, it will study how banks modify their balance sheets after a shock, taking also into account the macro-economic impact that such shock may entail. To this end, the study estimates elasticities and tests alternative liquidation rules. This analysis allows us to evaluate the impact of idiosyncratic or macroeconomic shocks on specific banks and the banking sector as a whole. In addition, it will permit us to identify the main channels through which these effects materialise.
Importantly, the paper explains how the distribution of leverage, risk exposures, and funding across banks contributes to systemic risk. Moreover, the AV index can serve as systemic risk measure and early warning indicator. Its main advantage is that it is based on individual banks’ balance sheet data. The fine granularity offered by balance sheet data provides a detailed overview of the evolution, composition and determinants of fire-sales vulnerability in the euro area banking sector.