Assets Overlapping Networks and Stress Testing on stability of Financial Systems

Financial networks, creating potential propagation channels for shocks in crises, are widely viewed as a key factor to systemic stability. In this paper, we develop a dynamic model of deleveraging in an overlapping network of assets. We study the deleveraging spirals driven by the interaction between fire sales and confidence effects, and show how distress is amplified and propagated throughout the network. Using the regulatory data from the Peoples Bank of China (PBC), we construct the assets overlapping network and then apply the model to the system. The result suggests that: (1) the mutually reinforcing effects of fire sales and confidence can contribute to contagion significantly; (2) The vulnerability of the system are largely dependant on the distribution of large illiquid assets. Our model provides a ready-to-use yet powerful stress testing tool for macro-prudential regulation.