A system-wide scenario analysis of large-scale corporate bond downgrades

Economics

European Systemic Risk Board

Portes R;Fell J;Mazzaferro F;Schaaning E

Richard Portes

2020

The coronavirus (COVID-19) pandemic has inflicted a severe and unprecedented shock on the economies of Europe and the world. Against this background, the General Board of the European Systemic Risk Board (ESRB) decided at its meeting on 2 April 2020 to focus its attention on five priority areas where coordination among authorities or across the EU is likely to be particularly important in order to safeguard financial stability. One of those five priority areas was the procyclical impact that downgrades of corporate bonds might have on markets and entities across the financial system. Following an issues note on the topic which describes the main issues, this report summarises the findings of a top-down analysis that attempts to quantify the impact of a mass bond downgrade scenario on the financial system. While the report focuses on European financial institutions when considering the impact of forced bond sales, the estimates of forced sale volumes include global (non-European) passive investment funds, given that sales of their holdings would also have an impact on European institutions holding the same assets. The main focus is on the potential sales of “fallen angels” (corporate bonds which were formerly investment grade but have been downgraded to high yield) and covers only “plain vanilla” financial and non-financial corporate bonds (thus excluding unrated financial and non-financial corporate bonds, sovereign bonds, securitisations and covered bonds, among others). The report uses data and models from the European Supervisory Authorities (ESAs), the European Central Bank (ECB), the ESRB Secretariat and the Bank of England. The results have not been validated in a bottom-up exercise involving any individual financial institution.

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