Breeding one's own sub-prime crisis: The labour market effects on financial system stability

Crisis may spread through economy via the propagating mechanisms of the labour market - households becoming delinquent due to an initial unemployment shock may be unable to continue servicing obligations versus the financial system. With large debts - e.g. mortgages - such defaults pose a threat to financial system stability. In this paper we use the Polish household budget surveys to simulate the impact of changes in the labour market status of household members on the ability of the household to service its mortgage payments. The simulation results are subsequently aggregated to facilitate a macro-level interpretation of the findings. We simulate various scenarios of labour market deterioration. Finally, we also introduce a policy instrument into the simulations providing, in a fiscally neutral manner, additional stability to the financial system. Based on robustness checks, the findings seem to be reliable. The results suggest that even with shares of debtors among consumers as low as in Poland, the propagation mechanism may indeed result in a considerable threat, while the fiscally neutral instrument is effective and well-suited to be addressed in providing additional stability to the financial system.