Quantifying Contagion Risk in Funding Markets: A Model-Based Stress-Testing Approach

Kartik Anand, Céline Gauthier & Moez Souissi
We propose a tractable, model-based stress-testing framework where the solvency risks, funding liquidity risks and market risks of banks are intertwined. We highlight how coordination failure between a bank’s creditors and adverse selection in the secondary market for the bank’s assets interact, leading to a vicious cycle that can drive otherwise solvent banks to illiquidity. Investors’ pessimism over the quality of a bank’s assets reduces the bank’s recourse to liquidity, which exacerbates the incidence of...
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