How Likely is Contagion in Financial Networks?
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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