27 - Sector-Level Financial Networks and Macroprudential Risk Analysis in the Euro Area

Summary

Abstract Recent interest in macroprudential analysis has highlighted the need for models that can identify counterparty risk exposures and shock transmission channels at the systemic level. We use data from the euro area financial accounts (flow of funds) to construct a sector-level network of bilateral balance sheet exposures. We then use the contingent claims approach to extend this accounting-based network of interlinked exposures to risk-based balance sheets which are sensitive to changes in leverage and asset volatility. We conclude that the bilateral cross-sector exposures in the euro area financial system constitute important channels through which local risk exposures and balance sheet dislocations can be transmitted, with the financial intermediaries playing a key role in the processes.

Keywords Financial networks, contingent claims analysis, macro-prudential analysis, financial accounts. JEL Classification: C22, E01, E21, E44, F36, G01, G12, G14

Introduction

Macroprudential analysis typically involves identification of risks, vulnerabilities and potential triggering events which, if crystallized, could flip the state of the financial system from stability to instability. But the events of the recent global financial turmoil have demonstrated that macroprudential analysis should, perhaps first and foremost, also aim at identifying links between sectors and channels through which local shocks may propagate wider in the financial system. Seeing the financial part of the economy as a network of interlinked exposures can help to detect such transmission mechanisms. Analysis of this financial network may then reveal that parts of the system that might not be considered particularly vulnerable to a given adverse scenario could still be affected due to their close interconnection with sectors that are directly confronted by the unforeseen events.