Interbank Exposures and Risk of Contagion in Crises: Evidence from Finland in the 1990s and the 2000s

By analysing the risk of interbank contagion during two distinctive crises, namely the Finnish banking crisis in the 1990s and the most recent financial crisis of the 2000s, this paper provides evidence on negative domino effects in a small open economy with a concentrated banking system. Simulations based on interbank exposures and maximum entropy estimations shed light on the magnitude of the contagion and the vulnerability to cross-border risks. The results show that just before the onset of the Finnish banking crisis the contagion would have affected almost half of the banking system, indicating that without the government bailout the implications for society would have been severe. In the 2000s the domestic contagion peaked after the collapse of Lehman Brothers and amid the sovereign debt crisis. The analysis suggests that the higher the concentration of the banking system, the more vulnerable it is to severe contagion. Moreover, strong interbank linkages with foreign banks increase the domestic risks.