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Financial interlinkages in the United Kingdom's interbank market and the risk of contagion

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  • Simon Wells

Abstract

A well functioning interbank market is essential for efficient financial intermediation. But interbank exposures imply the possibility of direct contagion: the insolvency of a single institution may trigger multiple bank failures due to direct credit exposures. The complete network of interbank exposures that gives rise to this channel of contagion is not observable, making it difficult to assess the systemic risk it poses. This paper uses data on loans and deposits between UK-resident banks to estimate the distribution of bilateral exposures. The potential for contagion is examined by assuming the sudden failure of each individual bank and estimating the losses incurred to other banks as a result of the initial shock. This study suggests that, while a single bank failure is rarely sufficient to trigger the outright failure of other banks, it does have the potential to weaken substantially the capital holdings of the banking system. And, when the failure of a single bank does result in knock-on effects, their severity depends greatly on the maintained assumptions about the distribution of interbank loans and the level of loss given default. But data constraints mean that drawing definitive conclusions is difficult.

Suggested Citation

  • Simon Wells, 2004. "Financial interlinkages in the United Kingdom's interbank market and the risk of contagion," Bank of England working papers 230, Bank of England.
  • Handle: RePEc:boe:boeewp:230
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    File URL: http://www.bankofengland.co.uk/research/Documents/workingpapers/2004/WP230.pdf
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    1. C. H. Furfine, 1999. "Interbank exposures: quantifying the risk of contagion," BIS Working Papers 70, Bank for International Settlements.
    2. Helmut Elsinger & Alfred Lehar & Martin Summer, 2006. "Risk Assessment for Banking Systems," Management Science, INFORMS, vol. 52(9), pages 1301-1314, September.
    3. Upper, Christian & Worms, Andreas, 2004. "Estimating bilateral exposures in the German interbank market: Is there a danger of contagion?," European Economic Review, Elsevier, vol. 48(4), pages 827-849, August.
    4. Gorton, Gary, 1988. "Banking Panics and Business Cycles," Oxford Economic Papers, Oxford University Press, vol. 40(4), pages 751-781, December.
    5. Franklin Allen & Douglas Gale, 1998. "Financial Contagion Journal of Political Economy," Center for Financial Institutions Working Papers 98-31, Wharton School Center for Financial Institutions, University of Pennsylvania.
    6. George Sheldon & Martin Maurer, 1998. "Interbank Lending and Systemic Risk: An Empirical Analysis for Switzerland," Swiss Journal of Economics and Statistics (SJES), Swiss Society of Economics and Statistics (SSES), vol. 134(IV), pages 685-704, December.
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