Quantifying the Impact of Energy Prices on Financial Stability

Abstract: Financial stability has always been at the forefront of research for both academics and practitioners alike. Given the current Russian invasion of Ukraine and the importance of energy commodities to the economic and strategic integrity of countries, understanding the importance of energy commodity price fluctuations on financial stability is of crucial importance. Current literature has fallen short of being able to quantify and explore such an issue through an all-inclusive approach. This has resulted in a split between the academic literature strands of Financial Stability and Energy Economics and Finance. This research, hence, aims to solve this issue by quantifying the risk posed to the European financial system from energy commodity price fluctuations through the implementation of an interdisciplinary approach. We propose a new methodology for doing so by building on Adrian and Brunnermeier’s (2016) ΔCoVaR. This research is split into two sections: Section A pertains to quantifying said risk indirectly by calculating the ΔCoVaR of economic segments before employing panel regression analysis on said variable to deduce the impact of energy commodity prices on the total risk posed to the financial system. Section B pertains to measuring such an impact directly through modifying the definition of ΔCoVaR to be conditioned on the gain of an asset rather than a loss, before then employing time-series analysis on the newly created variable. Moreover, machine learning techniques are employed to ensure the robustness of our results. We find conflicting results from our two approaches in regard to prior academic literature findings. Overall, from the results of our study we can deduce that on average energy commodities are not as important to financial stability as originally thought and that central banks have many tools at their disposals to deal with the risk posed to the system by energy commodity price fluctuations. This all suggests that imposing sanctions on energy imports from Russia would not harm the financial integrity of the European continent if the correct actions are to be taken.