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How Likely is Contagion in Financial Networks?

  • H Peyton Young
  • Paul Glasserman

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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File URL: http://www.economics.ox.ac.uk/materials/papers/12619/paper642.pdf
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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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Web page: http://www.economics.ox.ac.uk/
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  1. 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.
  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, 2011. "Simulation methods to assess the danger of contagion in interbank markets," Journal of Financial Stability, Elsevier, vol. 7(3), pages 111-125, August.
  4. Rodrigo Cifuentes & Gianluigi Ferrucci & Hyun Song Shin, 2005. "Liquidity risk and contagion," Bank of England working papers 264, Bank of England.
  5. Nier, Erlend & Yang, Jing & Yorulmazer, Tanju & Alentorn, Amadeo, 2007. "Network models and financial stability," Journal of Economic Dynamics and Control, Elsevier, vol. 31(6), pages 2033-2060, June.
  6. Gai, Prasanna & Kapadia, Sujit, 2010. "Contagion in financial networks," Bank of England working papers 383, Bank of England.
  7. Hans Degryse & Grégory Nguyen, 2004. "Interbank exposures: an empirical examination of systemic risk in the Belgian banking system," Working Paper Research 43, National Bank of Belgium.
  8. Charles A.E. Goodhart & Pojanart Sunirand & Dimitrios P. Tsomocos, 2004. "A Model to Analyse Financial Fragility: Applications," OFRC Working Papers Series 2004fe05, Oxford Financial Research Centre.
  9. 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.
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