Scenario-free analyses of financial stability with interacting contagion channels

The Great Financial Crisis of '07/'08 highlighted the dangers of instabilities in financial systems. In unstable financial systems, an initially small and localized financial shock may be amplified and spread throughout the system in a process referred to as financial contagion. Various channels of contagion exist, and propagate shocks through a deterioration of the liquidity and solvency of institutions, decreases in the market prices of tradable securities, etc. Contagion channels interact and amplify one another, such that the channels' collective impact may far exceed the sum of the individual channels' contributions. Exposures are an important measure of risk that does not rely on an initial stress scenario. When assessing an institution's exposure to the default of a counterparty, traditional exposure measures focus on direct exposures. Since the Global Financial Crisis, indirect exposures via common asset holdings are increasingly recognised too. Yet direct and indirect exposures fail to capture the losses that result from shock propagation and amplification following the counterparty's default. We refer to those spill-over losses as higher-order exposures and contribute to the literature on financial exposures by proposing a way to formalize and quantify them. Using granular data of the South African financial system and a contagion model that captures the most commonly studied contagion channels and their interactions, we show that higher-order exposures make up a significant part of exposures – particularly during times of financial distress when exposures matter most. We also show that higher-order exposures cannot simply be extrapolated from direct or indirect exposures, since they depend strongly on the network structure and the robustness of individual institutions. As the higher-order exposures we propose capture various contagion channels and their interactions without reliance on an initial stress scenario, they are an objective measure of systemic risks that may go unnoticed when using other ...