Many commentators on the global financial crisis identified ‘fire sales’ as one of the key mechanisms by which shocks to banks were amplified and transmitted across the wider financial system. When firms in distress sell assets held by other institutions at discounted prices, losses can spread through the financial system as prices fall, amplifying the initial stress. In a working paper published last year, we explored this mechanism by presenting a new model of fire sales. In doing so, we answer the following questions: Which types of financial shocks combine to produce fire sales? How can banks optimally liquidate their portfolios when forced to do so? How big a risk are bank fire sales?
Marco Bardoscia, Paolo Barucca, Adam Brinley Codd and John Hill
The failure of Lehman Brothers on 15 September 2008 sent shockwaves around the world. But the losses at Lehman Brothers were only the start of the problem. The price of their bonds halved, almost overnight. Other institutions that held Lehman’s debt faced huge losses, and markets feared that those losses could trigger further failures. The good news is that our latest research suggests that risks within the UK banking system from one such contagion channel, “solvency contagion”, have declined sharply since 2008. We have developed a new model which quantifies risk from this channel, and helps us understand why it has fallen. Regulators are using the model to monitor this particular source of risk as part of the Bank’s annual concurrent stress test exercise.
How might banks fare in stressful macroeconomic conditions? Are they strong enough to withstand the stress and survive or will they fall like dominoes? Stress tests offer insights into such questions.
Regulators are not only making a growing usage of such tests, they are also increasingly inclined to communicate openly about them. This is a remarkable evolution. Throughout history, regulators have typically followed some form of Hippocratic Oath and refrained from disclosing their detailed diagnostics of individual banks’ health. Regulators are now increasingly keen to release both the “answer” to stress tests (the results) and the “question” – the stress scenario regulators confront banks with. This column suggests that the disclosure of the scenario can be as important as – if not more than – the disclosure of the results.
Capital requirements for financial institutions are typically calculated using a statistical model and a risk measure such as VaR, whereas stress tests designed by regulators and risk managers are often based on subjective scenarios with no associated probability level. The stress test cannot therefore be easily linked to the capital measure. Taking insurance as an example, we show how to establish the link using intuitive tools which (i) respect the stress test designer’s intuition about causal direction, (ii) can be calibrated to pre-determined parameters such as correlations between risks, and (iii) can be easily communicated to and challenged by non-technical audiences.