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01.16.19

Bank asset-based contagion is a potential source of risk to financial stability, say Cleveland Fed researchers

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But the researchers say, at present, the overall risk from this channel is likely limited

One potential threat to a stable financial system is the phenomenon of contagion, where a risk that is ordinarily small becomes a problem because of the way it spreads to other institutions. Federal Reserve Bank of Cleveland researchers Jan-Peter Siedlarek and Nicholas Fritsch examined two of multiple channels through which contagion might occur – banks borrowing from each other and banks holding similar types of assets – and argue that the latter is a potential source of systemic risk. However, based on a review of recent data on the asset concentrations and capitalization levels of the largest US banks, the researchers conclude that the overall risk from asset-based contagion is at present likely limited.

“High-level data on the asset holdings of the largest bank holding companies in the US suggest that as of June 2017 banks' portfolios overlap significantly in some categories,” say Siedlarek and Fritsch, in particular, in agency mortgage-backed securities (MBS), Treasury and agency securities, and asset-backed (ABS) and other securities. However, the researchers note that agency MBS and Treasury and agency securities tend to be fairly liquid and are widely held outside the banking system. And while prices for ABS and other types of securities are more likely to be affected by significant sales by the banks in their sample, Siedlarek and Fritsch say this asset class is held mostly by two banks in the sample; thus any spillovers to other large banks may be limited. “This,” say the researchers, “together with the relatively high capitalization ratios among the largest banks, suggests that the potential for systemic risk via contagion from the asset commonality channel is limited at present.”

The authors caution that existing studies of asset-based contagion model financial institutions as fairly passive in response to a developing crisis. “Among other limitations, this approach leaves out the potential for accelerating effects arising from banks acting strategically and with foresight,” say the researchers. They note, for example, that if financial institutions adjust their behavior as they did around the failure of Lehman Brothers in 2008, these adjustments can lead to responses such as a reduction in interbank lending or liquidity hoarding that are significantly stronger than the mechanistic asset sales posited in the studies they cite.

The researchers also examined studies of another channel through which contagion might arise among financial institutions – through their lending to each other. “A common finding in the empirical studies is that real-world financial systems tend to be fairly robust to shocks through the interbank lending network,"” say Siedlarek and Fritsch. “In addition, results from theoretical research also suggest that the shocks and bankruptcy costs that are required for the interbank lending channel to lead to systemwide contagion have to be very large.”

Read Asset Commonality in US Banks and Financial Stability.

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