Capital requirements, liquidity and financial stability: The case of Brazil

• We model a network of banks in which shocks propagate through three channels.
• We study how different types of shocks affect losses in a real banking system.
• Systemic losses amplification (procyclicality) increase with shock magnitudes.
• Higher prices decay rates are associated with higher shock amplification.
• Medium-sized banks' shares in total losses decrease as the shock severity increases.

This paper simulates the effects of credit risk, changes in capital requirements and price shocks on the Brazilian banking system. We perform the analysis within the context of a model that integrates data on bilateral exposures in the interbank market with information about the liquidity profile of each financial institution. Asset prices in the model are determined endogenously as a function of the total volume of fire sales, thus creating the possibility that marking to market may trigger new rounds of fire sales and downward asset price spirals. The simulation results show that the Brazilian banking system is robust, as relatively large increases in the NPL ratio lead to only modest losses in the system. We also compute the contribution of each financial institution to systemic losses under severe shocks and find that contributions from medium-sized banks can be significant. However, if shocks become more severe, only large banks will contribute significantly to systemic losses.