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How Likely is Contagion in Financial Networks?

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  • H Peyton Young
  • Paul Glasserman
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    Abstract

    Interconnections among financial institutions create potential channels for contagion and amplification of shocks to the financial system.� We propose precise definitions of these concepts and analyze their magnitude.� Contagion occurs when a shock to the assets of a single firm causes other firms to default through the network of obligations; amplification occurs when losses among defaulting nodes keep escalating due to their indebtedness to one another.� Contagion is weak if the probability of default through contagion is no greater than the probability of default through independent direct shocks to the defaulting nodes.� We derive a general formula which shows that, for a wide variety of shock distributions, contagion is weak unless the triggering node is large and/or highly leveraged compared to the nodes it topples through contagion.� We also estimate how much the interconnections between nodes increase total losses beyond the level that would be incurred without interconnections.� A distinguishing feature of our approach is that the results do not depend on the specific topology: they hold for any financial network with a given distribution of bank sizes and leverage levels.� We apply the framework to European Banking Authority data and show that both the probability of contagion and the expected increase in losses are small under a wide variety of shock distributions.� Our conclusion is that the direct transmission of shocks through payment obligations does not have a major effect on defaults and losses; other mechanisms such as loss of confidence and declines in credit quality are more llikely sources of contagion.

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    Bibliographic Info

    Paper provided by University of Oxford, Department of Economics in its series Economics Series Working Papers with number 642.

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    Date of creation: 05 Feb 2013
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    Handle: RePEc:oxf:wpaper:642

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    Keywords: Systemic risk; contagion; financial network;

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    1. Charles Goodhart & Pojanart Sunirand & Dimitrios P. Tsomocos, 2004. "A model to analyse financial fragility: applications," LSE Research Online Documents on Economics 24680, London School of Economics and Political Science, LSE Library.
    2. Helmut Elsinger & Alfred Lehar & Martin Summer, 2002. "Risk Assessment for Banking Systems," Working Papers 79, Oesterreichische Nationalbank (Austrian Central Bank).
    3. Battiston, Stefano & Gatti, Domenico Delli & Gallegati, Mauro & Greenwald, Bruce & Stiglitz, Joseph E., 2012. "Default cascades: When does risk diversification increase stability?," Journal of Financial Stability, Elsevier, vol. 8(3), pages 138-149.
    4. Georg, Co-Pierre, 2011. "The effect of the interbank network structure on contagion and common shocks," Discussion Paper Series 2: Banking and Financial Studies 2011,12, Deutsche Bundesbank, Research Centre.
    5. Nier, Erlend & Yang, Jing & Yorulmazer, Tanju & Alentorn, Amadeo, 2008. "Network models and financial stability," Bank of England working papers 346, Bank of England.
    6. Rodrigo Cifuentes & Hyun Song Shin & Gianluigi Ferrucci, 2005. "Liquidity Risk and Contagion," Journal of the European Economic Association, MIT Press, vol. 3(2-3), pages 556-566, 04/05.
    7. Rodrigo Cifuentes & Gianluigi Ferrucci & Hyun Song Shin, 2005. "Liquidity risk and contagion," Bank of England working papers 264, Bank of England.
    8. Gai, Prasanna & Kapadia, Sujit, 2010. "Contagion in financial networks," Bank of England working papers 383, Bank of England.
    9. Upper, Christian, 2011. "Simulation methods to assess the danger of contagion in interbank markets," Journal of Financial Stability, Elsevier, vol. 7(3), pages 111-125, August.
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