Model reveals supply chain risks pose major threat to financial stability

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The recent Volkswagen crisis underscores how supply chain disruptions can magnify financial risks. A new model, developed by the Complexity Science Hub (CSH), shows how risks spread from the real economy to the financial sector.

When Europe's largest car manufacturer faces significant challenges, the impact extends far beyond the automotive industry—potentially threatening the broader financial system. Volkswagen's recent announcement of job cuts, coupled with similar warnings from auto parts supplier Bosch, in Germany, and also Brawe and Adient, in Czechia, highlights the growing risks.

As the crisis at VW deepens, it could exacerbate existing economic instability. In response to Volkswagen's factories closing, Moody's lowered its creditworthiness outlook. In addition, in its recent Financial Stability Report, the German Central Bank anticipates corporate defaults for the country in 2025.

"This situation underscores how supply chain disruptions can magnify financial risks," says CSH scientist Zlata Tabachová who, together with a team of researchers, developed a novel model that quantifies the critical role of supply chain disruptions in amplifying financial risks, with profound implications for credit risk assessment and financial stability.

The model shows that disruptions in supply chains can escalate financial losses far beyond traditional credit risks assessments. According to the researchers, in the event of a supply chain shock, banks' financial losses could be up to five times higher than the expected losses predicted by traditional credit risk models that do not account for supply chain contagion.

"Our findings highlight that traditional credit risk models typically relying on financial performance of corporate clients may underestimate the real financial exposure of banks to supply chain disruptions," evaluates Tabachová.

For the novel model, the researchers used an extensive, nation-wide dataset of over 240,000 Hungarian firms and 27 banks, along with more than 1.1 million supply chain links and over 25,000 bank-firm loans. "This multi-layer network model represents a step forward in the assessment of true credit risk," says Tabachová.

"Traditionally, banks evaluate risk based mainly on client information and their first-order suppliers and buyers. But in reality, these firms are deeply interconnected through higher-order supply chains, and disruptions to one link can cascade throughout the entire system."

Very few firms

In addition, Tabachová and her colleagues report in the Journal of Financial Stability that the risk posed by individual firms can be much greater than previously thought.

A small fraction of firms, those most connected within the supply chain or supplying essential inputs for production, could trigger defaults that lead to up to 22% of the total equity loss in the banking system. Importantly, these losses are predominantly indirect—resulting from defaults caused by supply chain disruptions, not from the initial failures themselves.

"We found that many of the systemically important firms are essential to the production in the country," explains Tabachová.

The study suggests that financial regulators need to rethink how they monitor systemic risks. While firms with large loan portfolios are typically considered the most important for financial stability, the researchers argue that those firms with the potential to trigger widespread defaults—due to their central role in supply chains—deserve more attention.

"This type of firm would be clearly missed when not taking supply chain contagion into account. Regulators could benefit from building up capabilities to monitor supply chain generated and amplified systemic risks," warn the researchers.

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Real-world crisis simulation

To further test their model's relevance, Tabachová and her colleagues simulated a real-world economic crisis inspired by the COVID-19 pandemic. Their simulations revealed that, without intervention, bank equity losses could reach as high as 6%. However, a modest liquidity injection—equivalent to just 0.5% of total bank equity—could reduce losses by more than 80% by providing targeted support to struggling firms, those illiquid but still solvent, according to the study.

"Our findings obtained from the COVID-19 inspired contagion example endorse the widespread practice of providing liquidity support to firms during crises. Yet, by gaining in-depth knowledge about the supply chain network contagion-caused losses of individual firms, financing support can be tailored in the most effective manner, while curbing the detrimental effects of the crisis and keeping inflation under control," say the researchers.

"Volkswagen is undeniably a systemically important firm with a significant influence that extends well beyond Germany's borders. A comprehensive understanding of its upstream and downstream supply chains is crucial for policymakers and regulators to facilitate a smooth and cost-effective transition aligned with climate policy objectives without a threat to financial stability," adds Tabachová.

More information: Zlata Tabachová et al, Estimating the impact of supply chain network contagion on financial stability, Journal of Financial Stability (2024). DOI: 10.1016/j.jfs.2024.101336

Provided by Complexity Science Hub Vienna