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Capturing information contagion in a stress-testing framework

Author

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  • Anand, Kartik
  • Gauthier, Céline
  • Gai, Prasanna S.
  • Souissi, Moez

Abstract

We develop an operational model of information contagion and show how it may be integrated into a mainstream, top-down, stress-testing framework to quantify systemic risk. The key transmission mechanism is a two-way interaction between the beliefs of secondary market investors and the coordination failure between the creditors of financial institutions. Pessimism about macroeconomic fundamentals triggers creditor runs, but also influences the fire sale discount applied to illiquid assets by secondary market investors. This hampers a troubled bank's recourse to liquidity and increases the incidence of bank runs, potentially unleashing a wave of investor pessimism that can drive otherwise solvent banks into illiquidity. We quantify this contagion channel in the context of the Bank of Canada's model of the Canadian banking system and a stress-test scenario used by the IMF during its 2013 evaluation of the Canadian financial sector.

Suggested Citation

  • Anand, Kartik & Gauthier, Céline & Gai, Prasanna S. & Souissi, Moez, 2016. "Capturing information contagion in a stress-testing framework," Discussion Papers 29/2016, Deutsche Bundesbank.
  • Handle: RePEc:zbw:bubdps:292016
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    References listed on IDEAS

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    1. Jean-Charles Rochet & Xavier Vives, 2004. "Coordination Failures and the Lender of Last Resort: Was Bagehot Right After All?," Journal of the European Economic Association, MIT Press, vol. 2(6), pages 1116-1147, December.
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    More about this item

    Keywords

    liquidity risk; contagion; stress testing; global games;

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • C72 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Noncooperative Games
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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