Market impact of portfolio deleveraging by financial institutions in stress scenarios leads to indirect, or price-mediated, contagion across institutions with similar holdings. This loss contagion may be modelled as a contagion process on a network defined by "liquidity-weighted overlaps" across portfolios.

We present an operational framework for quantifying the impact of deleveraging in stress scenarios by financial institutions subject to portfolio constraints. Using data on European banks, we show that such indirect contagion effects may modify the outcome of bank stress tests and lead to heterogeneous bank-level losses which cannot be replicated in a stress test without deleveraging effects. Our methodology distinguishes insolvency from illiquidity and quantifies the notion of “indirect exposure” to an asset class.

We design an indicator -the Indirect Contagion Index- which identifies banks which contribute most to indirect contagion and show that this indicator, based on portfolio holdings, correlates well with the outcome of systemic stress tests and provides a useful metric for interconnectedness complementary to those based on direct exposures.


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