Contagion Channels Research Articles

Non-banks contagion and the uneven mitigation of climate risk

This paper develops a framework for the short-term modelling of market risk and shock propagation in the investment funds sector, including bi-layer contagion effects through funds’ cross-holdings and overlapping exposures. Our work tackles chiefly climate risk, with a first-of-its-kind dual view of transition and physical climate risk exposures at the fund level. So far, while fund managers communicate more aggressively about their awareness of climate risk, it is still poorly assessed. Our analysis shows that the topology of the fund network matters and that both contagion channels are critical in its study. A stress test based on granular short-term transition shocks suggests that the differentiated integration of sustainability information by funds has made network amplification less likely, although first-round losses can be material. On the other hand, there is room for fund managers and regulators to consider physical risk better, and mitigate the second-round effects it induces, as these are less efficiently absorbed by investment funds. Improving transparency and setting relevant industry standards in this context would help mitigate short-term financial stability risks.

Effect of the U.S.–China Trade War on Stock Markets: A Financial Contagion Perspective

In this article, to model risk contagion between the U.S. and China stock markets based on high-frequency financial data, we develop a novel continuous-time jump-diffusion process. For example, we consider three channels for volatility contagion—such as integrated volatility, positive jump variation, and negative jump variation—and each stock market is able to affect the other stock market as an overnight risk factor. We develop a quasi-maximum likelihood estimator for model parameters and establish its asymptotic properties. Furthermore, to identify contagion channels and test the existence of a structural break with a known structural break date, we propose hypothesis test procedures. Using the proposed diffusion model with high-frequency financial data, we investigate the effect of the U.S.–China trade war on stock markets from a financial contagion perspective. From the empirical study, we find evidence of financial contagion from the United States to China and evidence that the risk contagion channel has changed from integrated volatility to negative jump variation.

Does foreign equity investment impact the spillover effect of industries in China?

This study aims to systematically investigate the impact of foreign equity investment on the spillover across industries in China, both in terms of the contagion path and persistence of shocks and the performance during the COVID-19 pandemic. We use daily data on returns covering 2014 to 2022 and apply linear and non-linear causality tests and spillover framework. Our findings show that the two proxies of foreign investment, net buying and Δ Net Buying, significantly shock the spillover across 11 industry indexes of China’s stock market, particularly the spillover output and long-term spillover received of sectors. During the COVID-19 pandemic, international investors are bullish on China’s economy reflected in the continuous inflow of northbound trading, and the short-run influence on China’s stock market is weakened, while the long-run impact remains. Moreover, financial networks suggest that the path of movement international capital movement to accomplish overall contagion through shock in certain specific industries. Overall, this study evidence that the northbound trading generally overlooked by researchers is indeed an important channel of financial contagion to China’s stock market.

Analysis of Dynamic Connectedness among Sovereign CDS Premia

This paper studies the dynamics of spillovers between sovereign Credit Default Swap (CDS) premia of nine countries, including Turkey, Russia, Brazil, South Africa, China, Germany, France, Italy and Spain. Weekly CDS data spans from July 2012 through June 2022. Adopting the methodology developed by Diebold & Yılmaz (2014), several connectedness measures are computed based on generalized forecast error variance decompositions generated through a time-varying parameter vector autoregressive model (TVP-VAR). The results show that the network’s connectedness level increased significantly during the COVID-19 outbreak and the Ukrainian war. Higher connectedness levels among European markets and developing countries are observed. Especially the connectedness levels between South Africa and other developing countries are remarkably high. The results reveal both fundamental-based and pure contagion channels and provide insight into the dynamic network of risk spillovers. A thorough understanding of international risk transmission channels is crucial for policy-makers and global investors regarding risk mitigation.

Systemic risk spillovers and the determinants in the stock markets of the Belt and Road countries

We construct time-varying tail risk networks to investigate systemic risk spillovers in the Belt and Road (B&R) stock markets during 2008–2021. Network metrics clearly reflect aggregate risk level and individual risk accumulation for the B&R stock markets under extreme events (e.g., 2008 financial crisis and COVID-19 pandemic). Tail-event driven network quantile regression analysis shows that network impacts of the B&R stock markets under different risk levels are asymmetric and regional heterogeneity. Panel analysis on determinants of systemic risk spillovers shows that cross-border investment and international trade are significant contagion channels while economic freedom is potential driver.

The risks of trading on cryptocurrencies: A regime-switching approach based on volatility jumps and co-jumping behaviours

ABSTRACT Previous research has shown volatility jumps and co-jumping behaviours in cryptocurrency markets. Motivated by these findings, we employ the herding effect and financial contagion channel to outline a theoretical framework of volatility-state-dependent correlations in cryptocurrency markets. We show that digital currency markets are more strongly correlated when experiencing an identical volatility regime, which echoes co-jumping behaviours addressed by the literature. Moreover, the strong correlation that occurs when the paired cryptocurrencies simultaneously experience a high volatility regime results in the least effectiveness of diversification in terms of a minimum portfolio risk reduction. Last but not least, the proposed state-dependent approach in this study proves effective at the task of risk forecasting and risk reduction for cryptocurrency portfolios, beyond the bivariate GARCH-based models, which are a pure and simple time-dependent approach.

Cross-border credit networks, banking risk contagion and suppression effects

From the perspective of risk contagion, it is difficult to balance the benefits and costs of banking globalization. We use data on cross-border syndicated loans intended to build heterogeneous credit networks among banking sectors in various countries to explore the introduction of banking risks into the network. Via social network analysis (SNA), we find that the global credit network has phased characteristics, and it is a source of exposure to global banking risks. However, the more important network position, that is, the greater centrality, identified shows that the banking industry is more stable. To explain these findings, we present and estimate the banking risk contagion model and the suppression effect model of contagion. Evidence suggests that the international credit network is the channel of risk contagion, and the long-term loan network and nonfinancial borrower network have a stronger contagion effect. Exogenous banking supervision and network endogenous closeness centrality can inhibit risk contagion. From a policy perspective, these findings indicate the need to supervise high-risk cross-border loans and maintain independence in the international credit network. Data Availability StatementThe data that support the findings of this study are available from the corresponding author, [Heng Zhao, email: zhao0501@mail.dlut.edu.cn], upon reasonable request.

Systemic Risk with Multi-Channel Risk Contagion in the Interbank Market

The systematicness of banks is an important driver of financial crisis. Overlapping portfolios and assets correlation of banks’ investment are important reasons for systemic risk contagion. The existing systemic risk models are all analyzed from one aspect and cannot reflect the real situation of the banking system. In the present paper, considering the overlapping portfolios and assets correlation, a contagion network model with multi-channel risk is proposed, which is with interbank lending (direct contagion channel), overlapping portfolios (indirect contagion channel), and assets correlation (indirect contagion channel). In addition, the model takes investment risk as an impact factor and learns the operation rules of the banking system to help banks compensate for liquidity through asset depreciation. Based on the proposed model, the effects of assets correlation, assets diversity, assets investment strategy, interbank network structure, and the impact of market density on risk contagion are studied and analyzed quantitatively. The method in this paper can more truly reflect the banking system risk than the existing model. This paper provides a solution for quantitative analysis of systemic risk, which provides powerful tools for macroprudential stress testing and a reference for regulatory authorities to prevent systemic risk.

Investor-Induced Cryptocurrency Contagion Channels: An Empirical Evidence from Five Major Economies

Coupled with the global pandemic and hyperinflation, the innovation risks of cryptocurrency have led to significant price volatility. There is a significant effect of cryptocurrencies on traditional financial markets and contagion channels. Therefore, regulatory authorities should understand the contagion channels to analyze the input risks and take necessary measures. This paper adopts the copula model to study the contagion channels of cryptocurrencies in five major economies. Additionally, three hypotheses are tested to determine whether investor induction serves as the main contagion channel. The empirical results indicate that cryptocurrency market contagion is significant in all five economies, with "portfolio rebalancing" as an important channel of transmission. Moreover, some countries represent time-varying contagion channels. Lastly, cryptocurrencies are not only an indirect symbol of the country’s integration into the global economy but also a risk indicator for new assets.

Cascading bankruptcies under simultaneous sectorial shocks: Theory and application to the Tunisian banking sector

AbstractThis paper proposes a theoretical framework modelling the effect of simultaneous sectorial shocks on the banking system resilience, in presence of overlapping portfolio risk. A sectorial shock decreases the value of banks' assets and solvency. We show that beyond a determined threshold, the regulator (central bank) shall intervene in order to avoid that simultaneous sectorial shocks lead to bankruptcies in a cascading process. The model is simulated in the context of the Tunisian banking system for a variety of extreme macroeconomic conditions (economic recession and inflation). The simulations show that the simultaneous shocks to industry, commerce and real estate sectors might lead to the bankruptcies of one to 10 banks among the 23 Tunisian banks via the cascading contagion channel, in the absence of a prompt and adequate intervention by the regulator.

Financial Contagion from the Subprime Crisis: A Copula Approach

The magnitude of the subprime crisis effects caused recessions in several economies, giving rise to the global financial crisis. The scale of this major shock and the different recovery profiles of European economies motivated this paper. The main objective is to look for evidence of contagion between the North American financial market (S&P500) and the financial markets of Portugal (PSI20), Spain (IBEX35), Greece (ATHEX) and Italy (FTSEMIB), in the South of Europe, and the financial markets of Sweden (OMXS30), Denmark (OMX2C0), Finland (OMXH25) and Norway (OsloOBX), in the North of Europe. Considering the period from January 1, 2003 to December 31, 2013, the ARMA-GARCH models were estimated to remove the autoregressive and conditional heteroscedastic effects from the time series of the daily returns. Then, the copula models were used to estimate the dependence relationships between the European stock indexes and the North American stock index, from the pre-crisis subperiod to the crisis subperiod. The results indicate financial contagion of the subprime crisis for all analyzed European countries. The North European markets intensified the relations of financial integration (both in negative and positive shocks) with the North American market, apart from the Danish against the Portuguese. In addition to the contribution made by the joint application of the ARMA-GARCH models, the findings are useful to identify channels of financial contagion between markets and to warn about the effects of possible new crisis, which will require different levels of adaptation by the companies’ financial managers and intervention by the authorities.

Bank default risk propagation along supply chains: Evidence from the U.K.

How does banks' default risk affect the probability of default of non-financial businesses? The literature has focused on the banks' direct corporate customers. It fails to consider the role of supply chain relationships as a powerful channel for default risk contagion. Our paper fills this gap by analyzing the direct as well as the indirect impact of banks' default risk on firms' default risk in the U.K. Relying on Input-Output tables, we devise methods that enable us to examine this question in the absence of data on firm-to-firm linkages. To capture all potential propagation channels, we account for horizontal and vertical linkages, both between the firm and upstream industries (suppliers) and between the firm and downstream industries (customers). We further examine how trade credit and contract specificity amplify or dampen the propagation of default risk. Our results show that increases in banks’ default risk from the banking crisis of 2007–2008 propagated strongly to U.K. non-financial firms via supply chains.

CREDIT RISK, LIQUIDITY RISK AND FEEDBACK EFFECTS ON MICROFINANCE INSTITUTIONS: AN EMPIRICAL EVIDENCE IN ECUADOR

Ten years of data from an Ecuadorian microfinance entity together with data on macroeconomic variables was analyzed. Through a Vector Autoregressive Model, we established a one-way causal relationship between credit and liquidity risks. The model includes the feedback effects through successive deterioration of credit portfolio and illiquidity spreading and the effects of macroeconomics and financial variables on these risks. Our results corroborate the importance of incorporating new contagion channels in microfinance institutions’ risk management, which helps microfinance institutions become financially sustainable, generating a relatively stable level of profitability that can improve the entrepreneur’s economic situation.

How vulnerable are interconnected portfolios of South African banks?

Price shocks that propagate through the financial system present a significant risk to financial system stability. This study was an evaluation of the vulnerability of South African banks’ portfolios to pricemediated contagion in the last decade. Using longitudinal data of balance sheet positions of the 10 largest banks from 2010 to 2020, the stress tests were triggered by price shocks on one marketable asset held by all banks: South African government bonds. Overall, the study found that second-order feedback effects from bank deleveraging are muted and that the concentrated structure of the South African banking system has a positive effect on shock absorption. However, a gradual trend towards more similar asset portfolios in the past 10 years has gradually increased exposure to the price-mediated contagion channel. Significance: The paper presents a novel modelling framework to study feedback price-effects in stress tests conducted on the South African banking system. A new data set shows the evolution of South African banks’ portfolio structure and vulnerability by computing two fragility metrics and a portfolio similarity measure. Using this data set, the relationship between banking sector vulnerability and portfolio similarity is tested empirically and it is shown how common asset holdings aggravate systemic risk to pricemediated contagion.

Scenario-free analysis of financial stability with interacting contagion channels

Financial stress tests that capture multiple interactions between contagion channels are conditional on specific, subjectively-imposed stress scenarios. Eigenvalue-based approaches, in contrast, provide a scenario-independent measure of systemic stability, but so far only handle a single contagion mechanism. We develop an eigenvalue-based approach that brings the best of both worlds, enabling the analysis of multiple interacting contagion channels without the need to impose a subjective stress scenario. Our model captures the solvency-liquidity nexus, which allows us to demonstrate that the instability due to interacting channels can far exceed that of the sum of the individual channels acting in isolation. The framework we develop is flexible and allows for calibration to the microstructure and contagion channels of real financial systems. Building on this framework, we derive an analytic stability criterion in the limit of a large number of institutions that gives the instability threshold as a function of the relative size and intensity of contagion channels. This analytical formula requires comparatively little data to elucidate the mechanisms that drive instability in real financial systems and thus complements the insights gained from traditional stress tests.

Simulace "systémového" rizika v důsledku náhlých výprodejů aktiv: Aplikace na bankovní sektor Evropské unie

The paper integrates elements of microstructural network models of the banking sector developed by Cont and Shaanning (2017) and Duarte and Eisenbach (2018) to simulate endogenously the fire sales contagion channel of systemic risk. The scale of the effect is illustrated on the EBA supervisory stress test results for 2018, based on which the secondary impact of fire sales increases aggregate losses by 69%. The model is used to identify banks with the highest contribution to systemic risk. Alternative systemicity predicators are proposed based on the results. The second section discusses the ability of the model to incorporate behavioural and regulatory aspects associated with the systemic risk, with the main focus on the impact of (i) calibration of regulatory leverage ratio limits, (ii) leverage ratio targeting, (iii) decrease in market liquidity, and (iv) change in the shape of the market price impact function on the dynamics of systemic losses due to the fire sales contagion.

Interbank Network as a Channel of Credit Contagion in Banks: Is Moral Hazard Transferable?

Abstract The objective of this research is to examine the inter-bank network of clients as a channel for credit risk transmission by groups of banks in Serbia characterized by different levels of credit risk (clusters). Two of the four observed groups of banks have experienced increase in NPLs through the channel of contagion spread in the interbank network. The spread of the infection through the banking network is a consequence of the impact of the economic connection among clients. The third group of banks (banks with high levels of credit risk) takes over the effects of systemic factors and transfers their influence to the second and the first group (banks with average and below-average credit risk level) through the banking network channel. There were different models of bank behaviour, from a group of banks that fully aligned their risk taking with risk capacity to a group of banks that exhibited an excessive risk propensity far beyond their own risk-taking capacity. There is also the confirmation that moral hazard was an important determinant of credit risk and an additional impulse to spread credit contagion.

High-Frequency Contagion between Aggregate and Regional Housing Markets of the United States with Financial Assets: Evidence from Multichannel Tests

This study examined contagion involving the aggregate and regional housing markets of the United States (US) with other asset markets using multichannel tests during the 2007–2008 global financial crisis based on a unique high-frequency, i.e., daily data set. To arrive at bias free results several contagion tests: the Forbes and Rigobon (FR) correlation test for contagion, the Fry, Martin and Tang coskewness (CS) test for contagion, the Hsiao cokurtosis (CK) test for contagion and the Hsiao covolatility (CV) test for contagion were employed. At the country level, the linear (correlation) channel indicates that contagion is present from (to) average housing returns to (from) the S&P500, with the correlation contagion also running from average housing returns to REITs. Moreover, the coskewness, cokurtosis and covolatility channels are strongly active with contagion running only from average housing returns to the S&P500, bond returns and REITs. At the Metropolitan Statistical Area (MSA) level, our results indicate that the linear (correlation) channel of contagion is relatively inactive, but the coskewness, cokurtosis and covolatility channels are strongly active with contagion running mostly from housing returns to the S&P500. Our results have important implications for investor and policymakers, given the possibility of differential results based on tests and whether we rely on regional or aggregate data.

Финансовое заражение российских компаний от рынка нефти под воздействием санкционного и пандемического шока

The article presents an overview of theoretical approaches to the study of the content and channels of financial contagion, the main methods and models of its quantitative analysis. The results of contemporary domestic and foreign studies devoted to the assessment of the intensity, direction and scale of contagion across countries and industries are discussed. We conclude that Russian researchers pay insufficient attention to this problem. In the practical part of the article, we test hypotheses about the transmission of contagion from the oil market to a number of Russian large companies belonging to different sectors of the economy. Sanctions and pandemic shocks are seen as external triggers for contagion. We use a large amount of oil and stock price data for a period that includes the 2014–2016 monetary and financial crisis and the 2020 pandemic crisis. To distinguish between periods of high and low market volatility, which is necessary to detect contagion, we calculate moving coefficients of variation for oil and stock prices. To identify cases of contagion, we employ the Forbes-Rigobon test, tests for coasymmetry and cocurtosis of distribution. The resulting estimates confirm numerous cases of contagion, with their number increasing as higher distribution moments are analysed. In addition, we conclude that during the 2014–2016 crisis, the Russian oil and gas industry showed the greatest vulnerability to contagion from the oil market. However, the pandemic shock changed the telecommunications sector turned out to be the most susceptible to contagion from the oil market in Russia. The banking sector in both crises showed a high degree of contagion from the oil market. At the same time, companies associated with ferrous and non-ferrous metallurgy, mining and processing of precious metals, as well as the chemical industry demonstrated the greatest resistance to financial contagion.

Climate policy and financial system stability: evidence from Chinese fund markets

ABSTRACT The impacts of climate policies on the global financial system have aroused wide attention all over the world. Fund markets are an important part of the financial system and play a crucial role in the stability of the financial system. In this paper, the impacts of climate policies on fund markets are evaluated from direct and indirect risk contagion channels using the data of Chinese ordinary stock funds and partial stock hybrid funds during 2007–2020. Risk contagion indicates that a fund's selling of stocks causes the stock price to fall, causing asset losses to other funds holding the same stocks. We construct a risk contagion model based on common asset holdings of funds. The analysis of direct risk exposure of funds to climate policy in China shows that five climate-policy-relevant sectors account for more than half of the total value of shareholdings. The climate risk stress-test indicates that ignoring the indirect risk contagion channel significantly underestimates the adverse effects of and climate policies on fund markets. More stringent, short-term climate targets and earlier implementation of climate policies helps to mitigate otherwise drastic changes required in energy markets in China to achieve a 2°C long-term target, and reduces the adverse effects of climate policies on the fund market. Furthermore, the impact of climate policies on different investment funds shows significant differences, leading to winners and losers. The losers are funds that adopt a high-carbon investment strategy, while winners are funds adopting a green investment strategy.