Network model of credit risk contagion in the interbank market by considering bank runs and the fire sale of external assets

We construct a network model of credit risk contagion in the interbank lending market based on time series. Such network model is based on imperfect information considering that the initial credit default of the debt bank will cause the creditor bank to run on its debt bank and the debt bank’s fire sale of external assets held to repay the debt or control the leverage ratio that reduce asset prices and create spillovers. By the theoretical deduction and simulation method, we study how the contagion effects of credit risk accumulate and spread in the interbank market network. In addition, we study the evolution characteristics of credit risk contagion caused by the initial default of debt banks in the interbank market. The following are the results of the study. First, when banks sell external assets at a fixed price, the fire sale of external assets can effectively reduce the probability of credit default. However, when the price of external assets decrease with the increase of fire sales volume, banks’ fire sale of external assets will lead to more serious contagion spillover consequences than that of none of the banks’ selling strategies. Second, the panic of bank decision makers in the banking system has a nonlinear evolution characteristic of increasing and decreasing credit risk contagion. Third, the higher the proportion of banks’ liquid assets, the stronger their ability to resist credit risks. Last, the higher the proportion of banks’ interbank assets, the stronger the contagion effect of credit risk on the entire banking system.