A system-wide stress testing for Luxembourg financial sector

We develop a structural framework for system-wide financial stress testing with multiple interacting contagion and amplification effects acting through a dual channel of liquidity and solvency risk. The framework allows us to identify vulnerabilities arising from the increasingly intricate and complex financial system of banks and investment funds in Luxembourg. Based on exogenous shocks stemming from hypothetical adverse scenarios, several important findings are documented for banks and three types of investment funds (Bond Funds, Equity Funds and Mixed Funds) during 2020-2023. First, the simulated shocks have significant first-round and higher-order effects on investment funds, in particular on Equity Funds. Moreover, Bond Funds display a stronger amplification factor than other types of investment funds. Second, the impact on Luxembourg banks is substantially muted. The overall bank capital depletion, measured by the total risk exposure amount, is low even in view of the tail risk metrics, which reflects the strong resilience of the Luxembourg banking sector as a whole. Third, for both investment funds and banks, their vulnerabilities still reflect the procyclicality of the financial system. Overall, the joint modelling of banks and non-banks delivers clear benefits to the analytical capabilities of central banks and informs policymakers in developing the non-bank macroprudential toolkit of the future.