Linking Distress of Financial Institutions to Macrofinancial Shocks

This paper links granular data of financial institutions to global macroeconomic variables using an infinite-dimensional vector autoregressive (IVAR) model framework. This framework is used to assess the impact of foreign macroeconomic shocks on default risks of euro area financial firms. In addition, the macroeconomic impact of firm-specific shocks is investigated. The approach taken nests a global VAR (GVAR) model, which allows an assessment of the two-way links between the financial system and the macroeconomy, while accounting for heterogeneity among financial institutions and the role of international linkages in the transmission of shocks. The model is estimated using macroeconomic data for 21 countries and default probability estimates for 35 euro area financial institutions. Overall, the results show that accounting for heterogeneity among firms is important for investigating the transmisson of shocks through the financial system. The model also captures the important role of international linkages, showing that macroeconomic shocks scaled to those observed following the Lehman bankruptcy generate a rise in firm-level default probabilities that is close to those observed during this time period. By linking a firm-level framework to a global model, the IVAR approach provides promising avenues for developing macro-prudential tools that can explicitly model spillover effects among a potentially large group of firms, while accounting for the two-way linkages between the financial sector and the macroeconomy, which were key transmission channels during the recent financial crisis.