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Systemic Risk and Financial Vulnerabilities: Diagnosis and Solutions

Final Report Summary - SOLSYS (Systemic Risk and Financial Vulnerabilities: Diagnosis and Solutions)

In a research project encompassing various aspects of Financial Stability, the Solsys project has led to several new insights. We have formalized and quantified a measure of financial vulnerability based on the risk of fire sales cascading into a liquidation spiral: When a bank experiences a negative shock to its equity, one way to return to target leverage is to sell assets. If asset sales occur at depressed prices, then one bank's sales may impact other banks with common exposures, resulting in contagion. We propose a simple framework that accounts for how this effect adds up across the banking sector. We show how our model can be used to evaluate a variety of crisis interventions, such as mergers of good and bad banks and equity injections. We apply the framework to European banks vulnerable to sovereign risk in 2010 and 2011. We have also shown that asset prices are endogenous to the structure of the financial system by taking the example of the US banking sector. As banks moved from being state-wise to being cross-state businesses, the prices of real-estate assets have become heavily correlated across states, reflecting a common exposure to the financial health of a few large nationwide banks.