When Europe’s largest car manufacturer faces significant challenges, the repercussions ripple beyond the automotive sector, potentially threatening the broader financial system. This sentiment was underpinned by Volkswagen’s recent announcement of job cuts, which was echoed by similar warnings from Germany’s auto parts supplier Bosch, as well as Brawe and Adient in Czechia. These developments spotlight the escalating risks within the industry.
As Volkswagen grapples with deepening crises, the present economic instability could be exacerbated. The situation prompted Moody’s to revise its creditworthiness outlook following the shutdown of Volkswagen’s factories. Furthermore, in its recent Financial Stability Report, the German Central Bank projected an increase in corporate defaults nationwide by 2025.
“This scenario highlights the extent to which supply chain disruptions can amplify financial risks,” remarked CSH scientist Zlata Tabachová, who, along with her research team, developed an innovative model that delineates the pivotal role of supply chain disruptions in magnifying financial risks, thereby reshaping credit risk assessment and financial stability paradigms.
The researchers’ model illustrates that interruptions in supply chains can precipitate financial losses that substantially exceed those anticipated by traditional credit risk assessments. In scenarios of supply chain shocks, banks’ financial losses could quintuple compared to the losses foreseen by conventional credit risk models, which typically do not consider the ramifications of supply chain contagion.
“Our findings suggest that traditional credit risk models, which predominantly rely on the financial performance of corporate clients, tend to underestimate the genuine financial exposure of banks to supply chain disturbances,” Tabachová assessed.
For this groundbreaking model, the research team utilised an expansive dataset encompassing over 240,000 Hungarian companies and 27 banks, with more than 1.1 million supply chain connections and over 25,000 bank-firm loans. “This multi-layer network model marks a significant advancement in the accurate assessment of true credit risk,” Tabachová explained. “Traditionally, banks assess risk primarily based on client information and their immediate suppliers and buyers. However, these firms are intricately interconnected through more extensive supply chains, and disruptions at any point can trigger a cascade of effects across the entire network.”
Moreover, Tabachová and her colleagues disclosed in the Journal of Financial Stability that the risk posed by individual firms is considerably higher than previously assumed. A mere fraction of firms, especially those most integrated within the supply chain or those supplying critical production inputs, could instigate defaults leading to up to 22% of the total equity loss in the banking sector. Notably, these losses are predominantly indirect, stemming from defaults provoked by supply chain disruptions rather than the initial failures.
“We discovered that many of the systemically important firms are crucial for production within the country,” Tabachová noted.
The study posits that financial regulators must revisit their systemic risk monitoring approaches. While firms with large loan portfolios are usually considered pivotal for economic stability, the researchers advocate for more attention to those firms that could trigger widespread defaults due to their central roles in supply chains. “These types of firms would be overlooked if supply chain contagion is not considered. Regulators could enhance their capabilities to monitor risks generated and amplified through supply chains,” the researchers cautioned.
To validate the relevance of their model, Tabachová and her team conducted simulations of a real-world economic crisis inspired by the COVID-19 pandemic. Their simulations showed that, without intervention, bank equity losses could soar to as high as 6%. However, a modest liquidity injection, amounting to merely 0.5% of total bank equity, could mitigate losses by over 80%, thereby offering targeted support to illiquid yet solvent firms, per the study.
“Our findings from the Covid-19 inspired contagion scenario validate the common practice of providing liquidity support to firms during crises. By acquiring detailed insights into the supply chain network and the contagion-induced losses of individual firms, financial support can be tailored more effectively, mitigating the adverse impacts of the crisis while maintaining inflation control,” the researchers concluded.
“Volkswagen is undeniably a systemically important firm with a significant influence that extends well beyond Germany’s borders. A thorough understanding of its upstream and downstream supply chains is crucial for policymakers and regulators to ensure a smooth and cost-effective transition in line with climate policy objectives without jeopardising financial stability,” added Tabachová.
More information: Zlata Tabachová et al, Estimating the impact of supply chain network contagion on financial stability, Journal of Financial Stability. DOI: 10.1016/j.jfs.2024.101336
Journal information: Journal of Financial Stability Provided by Complexity Science Hub