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Measuring capital at risk with financial contagion: two-sector model with banks and insurers

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Listed:
  • Covi, Giovanni

    (Bank of England)

  • Huser, Anne-Caroline

    (Bank of England)

Abstract

How do interdependent economic shocks impact the financial system and reverberate within it? To model the financial system, we start with a two-sector microstructural model of the financial system that includes banks and insurers. We develop a stress testing methodology that stochastically computes economic profits and losses at banks and insurers following correlated corporate default shocks. Taking into account the feedback and amplification of the initial shock though the financial system, we quantify its impact on firms’ capital positions. This methodology is applied to a very rich panel data set of UK banks and insurers. Our approach enables us to distil the contribution of initial economic shocks and the feedback and amplification mechanisms to extreme tail events. Overall, we find that, since the Covid pandemic (2020–21), the UK financial system has experienced an improvement in both profit expectations and tail losses. Comparing sectoral losses in an extreme stress scenario, we find that insurers are more affected than banks by economic credit and traded risk losses, while fire sale losses affect banks more than insurers.

Suggested Citation

  • Covi, Giovanni & Huser, Anne-Caroline, 2024. "Measuring capital at risk with financial contagion: two-sector model with banks and insurers," Bank of England working papers 1081, Bank of England.
  • Handle: RePEc:boe:boeewp:1081
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    Credit risk portfolio; systemic risk; financial contagion; financial network; system‑wide stress testing;
    All these keywords.

    JEL classification:

    • D85 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Network Formation
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • L14 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Transactional Relationships; Contracts and Reputation

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