Prepared by Alberto Grassi, Michael Kosiahn, Chiara Lelli, María Losa Martín, Michael Moers, Matthias Sydow, Michael Vincent and Garbrand Wiersema.
Published as part of the Macroprudential Bulletin 32, November 2025.
This article expands on the 2025 EU-wide stress test by incorporating a system-wide perspective to capture contagion risks across investment funds and insurance corporations alongside the banking sector. It examines potential short-term contagion effects under the EBA’s adverse scenario as financial institutions adjust their balance sheets in response to stress. These adjustments would result in additional average CET1 ratio depletion of 29 basis points, increasing first-round effects by 12%. Among institutional sectors, investment funds – in particular equity funds – face the greatest losses under the EBA’s adverse scenario, while banks with less sophisticated hedging capabilities are also significantly affected. The findings emphasise the importance of a holistic, system-wide perspective to capture spillover effects both within and across financial sectors. Furthermore, the results show how solvency-driven liquidity shocks can trigger market reactions, which in turn propagate through the financial system and amplify the losses stemming from initial exogenous shocks. The article also includes two boxes which expand the way in which the EBA methodology accounts for counterparty credit risk. They do so by looking at exposures to additional institutional sectors such as central clearing counterparties (Box 1) and examining the losses that materialise when the failures of counterparties become more interdependent (Box 2).
This article expands on the 2025 EU-wide stress test to account for interactions across financial institutions by investigating amplification mechanisms. A sector-by-sector approach to stress testing can rigorously assess the resilience of individual financial institutions to severe shocks but may overlook key contagion channels and spillover effects within the broader financial system, understating the risks that can arise from interconnections between banks, insurers, investment funds and other financial institutions.
A system-wide perspective is essential to capture the full impact and transmission of financial shocks across the financial sector. The financial landscape is characterised by dense linkages and overlapping exposures, where shocks originating in one segment can propagate rapidly through liquidity, solvency and market channels to other sectors. These transmission mechanisms (such as forced asset sales, cascading price effects and cross-holdings) can amplify initial losses and generate unforeseen vulnerabilities at the system level.
The ECB’s Interconnected System-wide stress test Analytics (ISA) tool provides a framework to quantify these second-round effects and spillovers. By integrating granular data on bilateral exposures and portfolio holdings across banks, insurers and investment funds, the ISA tool offers a holistic view of systemic risk under the EBA adverse scenario. This approach makes it possible to assess both direct and indirect contagion, revealing the endogenous dynamics and amplification mechanisms that a purely sectoral analysis would miss. By capturing the full spectrum of vulnerabilities that can emerge from the interconnectedness of the financial system, a system-wide stress-testing framework is critical for understanding the resilience of the entire financial sector and designing effective macroprudential policies.
The contagion assessment provided by the ISA tool is complemented by two boxes which expand our understanding of counterparty credit risk beyond the EU-wide perspective. Box 1 leverages the annual central clearing counterparty (CCP) stress test performed by ESMA to explore the potential consequences of a CCP default on banks’ solvency. Box 2 investigates contagion effects through Monte Carlo simulation methods to capture the interconnected nature of counterparty defaults.
The granular dataset underpinning the system-wide analysis maps a rich network of interconnections among banks, insurers and investment funds. The network features 96 banks and 21,000 open-ended investment funds, each consolidated at group level. The analysis primarily focuses on the nearly 8,000 fund groups domiciled in the EU; non-EU funds play a secondary role. For the euro area insurance sector, the ISA tool uses country-level data. The data network reflects positions as at the end of 2024. All data are sourced from supervisory reporting and commercial data providers. Data on CCPs are not included in the network, but insights on risks from CCP-induced shocks are presented in Box 1.
The ISA model provides a comprehensive framework for assessing system-wide financial risks. Using network modelling, ISA quantifies both first-round losses (the direct impact of the adverse scenario on financial institutions) and second-round losses (which emerge as institutions respond to solvency and liquidity distress). These second-round effects illustrate the cascading risks caused by the interconnected nature of the financial system.
The system-wide analysis builds primarily on the EU-wide 2025 stress test market risk scenario, which affects all financial institutions at the same time. The scenario assumes corrections in asset prices and rising sovereign credit spreads, reflecting escalating vulnerabilities across markets and economies. This adverse scenario is assumed to impact banks instantaneously.
ISA comprises a sector-specific framework to calculate stress test losses under the adverse market risk scenario for all sectors. First, the tool assesses the effects of the exogenous shocks outlined in the EU-wide stress test adverse scenario. These primarily relate to the revaluation of security and fund holdings. For banks, first-round revaluation losses are further supplemented by the EU-wide stress test results for non-market risks (see Section 3.2 for further details). For investment funds, the decline in asset valuations leads to redemptions by investors. A flow-performance model is employed to project these outflows due to the decrease in asset prices. For insurers, liability-side adjustments are calculated, taking into account the discounting of future liabilities as well as profit-sharing clauses embedded in insurance policies. The solvency and liquidity distress generated in this phase then triggers the second-round reaction in the system.
EU-wide stress test results are fed into ISA to complement short-term dynamics stemming from market risk shocks with longer-term credit and profitability losses. This is done by incorporating adjusted longer-term impacts directly into the first-round loss calculations. The 2025 EU-wide stress test provides key inputs such as CET1 capital depletion over a multi-year horizon, capturing the medium to long-term emergence of credit and profitability risks. To align these outputs with the shorter time horizon of the ISA modelling framework, the projected adverse scenario losses for the first year of the 2025 EU-wide stress test are evenly distributed across the four quarters. Combined with the adverse market risk scenario shocks, this quarterly impact for non-market risk losses at bank level is fed into ISA for the first-round loss calculation. This approach ensures that the initial credit and profitability shocks are effectively integrated into the second-round contagion analysis.
In a second step, ISA propagates first-round losses across the system, drawing on bilateral exposures between banks, insurers and investment funds in the euro area. This involves several iterations. Each begins by calculating the losses incurred from defaults in the previous round. Next, liquidity is redistributed, with institutions holding liquidity surpluses lending to those facing shortfalls. Institutions unable to meet their liquidity needs instead have to redeem fund shares or undertake fire sales to raise cash. The cumulative impact of fire sales is assumed to drive further declines in asset prices, which are estimated using a predictive model. Entity-specific default criteria are evaluated at each round, and new defaults (if any) are identified at the end of each iteration. For banks, a default is assumed when the CET1 ratio falls below the minimum requirement of 4.5%. Moreover, an institution can become illiquid (called “liquidity default” in ISA) if liquid assets are insufficient to cover projected liquidity outflows. This iterative process continues until the losses converge to virtually zero.
Market risk exposures represent the largest share of financial system assets, accounting for 53% of the total of €92 trillion (Chart 1). These exposures to the market prices of bonds and equities vary significantly across sectors. Chart 1, which maps the cross-holdings between banks, insurers and investment funds as well as these institutions’ investments in other sectors, shows that banks’ market risk exposures make up only 15% (€4 trillion) of total assets. Insurers’ market risk exposures make up a higher share at 36% (€3 trillion), and investment funds exhibit the highest exposure, with 81% (€46 trillion) of their total assets linked to market risk. By contrast, credit risk exposures dominate the balance sheets of banks, comprising 74% (€20 trillion) of their total assets.
The network of bilateral links reveals dense financial linkages, including direct exposures and overlapping portfolios across sectors (Chart 1). Banks engage in lending with other financial institutions, resulting in counterparty risks and exposure to liquidity outflows. The banking sector is mostly exposed to sovereign bonds, which also make up a substantial portion of the securities held by the other two sectors. Meanwhile, investment funds are the primary holders of equity issued by non-financial corporations, while also maintaining sizeable interconnections within the investment fund sector. Institutions within the same sector tend to hold similar portfolios of tradable securities, which increases the risk of correlated losses among peers. This also means that when stressed institutions in the sector sell off their assets driving market prices down, the portfolio impact is further propagated to others in the same sector. Finally, insurers hold substantial investments in shares issued by funds. This exposes insurers to the market risk of funds and funds to redemption risk from insurers.
Stress impacts vary across sectors, with pronounced first-round losses followed by milder but still critical second-round effects. Investment funds, which are more exposed to market swings due to the composition of their portfolios, bear the brunt of the first and second-round losses (Chart 2, panel a). For banks, the modest losses can be attributed to their smaller exposures to financial markets and overall well-hedged positions (Section 3.3). Insurers – who invest both indirectly through funds and directly in securities – experience larger relative losses on their fund shares and direct holdings. These losses are, however, partially mitigated by adjustments to technical provisions on the liabilities side. Across sectors, second-round effects add moderate losses to first-round impacts, mainly stemming from funds’ fire sales of securities.
Investment funds are the most affected by both first and second-round losses. Fire sale shocks primarily affect portfolios of investment funds, due to their higher market risk exposure (see Section 3.1), which in turn transmit contagion to insurance corporations. Given that stock prices are more significantly affected by the EBA scenario than other asset classes, these mechanics weigh more heavily on funds that predominantly invest in equities. They suffer the majority of investor redemptions and need to sell more of their assets, in particular stocks. As a result, equity prices are most impacted by the fire sale. Such drops in market values reduce the value of fund shares, spreading the losses mainly toward insurance corporations (Chart 2, panel b).
For banks, the results of the EU-wide stress test serve as the foundation for analysing the effects of contagion and spillovers. To compute the first-round effects on banks implied by the EBA’s adverse scenario, the CET1 capital depletion reported in the 2025 EU-wide stress test is used. First-year non-market gains and losses incurred by banks (which represent the largest share of losses over the three-year period) are incorporated into the ISA model. Market risk losses for banks (as well as for all other sectors) are then re-estimated using ISA’s top-down satellite models.
To ensure alignment between the EU-wide bottom-up results and ISA’s first-round losses, hedging data provided by banks are fed into ISA. The hedge ratio used to capture the extent to which banks are hedged against market risk is calibrated so that ISA’s first-round losses match the depletion caused by market risk exposures observed in the EU-wide stress test results. This ensures that important information collected directly from banks is adequately reflected in the results of the ISA model. On average, a 10 percentage point decrease in the hedge ratio would result in an additional 40 basis points of CET1 ratio depletion, with significantly stronger effects observed for banks with substantial market positions, such as investment banks and global systemically important banks (G-SIBs).
Banks experience the steepest reduction in CET1 ratios during the first round of stress, with second-round effects adding moderate additional impacts. Aggregate depletion amounts to 239 basis points in the first round, with the largest declines observed among G-SIBs (Chart 3, panel a). Additionally, forced asset sales by investment funds cause prices to fall sharply, which subsequently affects banks (and insurers) through cross-holdings and shared exposures. These second-round effects contribute to average CET1 depletion for banks of about 29 basis points, with G-SIBs and universal banks impacted the most due to their reliance on activities exposed to market risk. By contrast, custodians and asset managers see the smallest reduction, since they manage client assets held in custody or segregated accounts instead of deploying their own balance sheet capital. Consequently, they are less susceptible to contagion risks.
On average, banks reported they were hedged against around 20% of market risks at the end of 2024, with those more active in financial markets being better protected. Conversely, around one-third of these banks have negative hedge ratios. This does not reflect conventional hedging but rather additional exposure to the underlying asset price movements, amplifying the impact of market shocks. The degree of hedging varies significantly, with investment banks, G-SIBs and asset managers being more hedged than banks with other business models (Chart 3, panel b). These results highlight banks’ different sensitivity to the market risk scenario, but do not imply full insurance against all types of shock. It is important to note that market risk positions can adjust quickly, leading to hedges that are only effective for a short period of time and a given strategy.
A system-wide approach makes it easier to understand how financial shocks propagate and intensify across the entire financial sector. The interconnected nature of today’s financial system, marked by intricate linkages and common exposures, means that stress originating in one segment can swiftly spread to others via liquidity strains, solvency pressures and market movements. Expanding the 2025 EU-wide stress test to cover other financial sectors and their interactions is key to obtaining a system-wide view of financial resilience.
This article quantifies the additional losses stemming from cross-sectoral interactions overlooked by sector-specific analyses. Based on the system-wide simulation, the banking sector experiences average CET1 depletion of 269 basis points in total in the first quarter, with 29 basis points attributable to second-round effects due to fire sales and losses on fund share holdings. At the same time, some banks experience significantly larger capital depletion than others due to their less effective hedging strategies. While the EU-wide stress test is geared towards assessing banking sector resilience, the system-wide results also highlight that the impact of adverse scenario shocks can be substantial for euro area non-bank financial institutions, making a strong case for further exploring financial vulnerabilities across sectors.
System-wide stress testing also provides insights for macroprudential policy. The ISA model shows that, while banks benefit from regulatory buffers, similar resilience mechanisms in the non-bank financial intermediation (NBFI) sector, particularly for investment funds, would be helpful to mitigate second-round amplification effects. By leveraging system-wide monitoring and tools like ISA, authorities can anticipate risks, strengthen resilience and enhance confidence in the financial system.
ESRB (2025), Macro-financial scenario for the 2025 EU-wide banking sector stress test.
Grassi, A. et al. (2026), “Default correlations and systemic risk”, mimeo.
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