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

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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 runs by creditors. This, in turn, makes investors more pessimistic, driving down other banks’ recourse to liquidity. We illustrate these dynamics in a calibrated stress-testing exercise.