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The credit quality channel: Modeling contagion in the interbank market

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  • Fink, Kilian
  • Krüger, Ulrich
  • Meller, Barbara
  • Wong, Lui-Hsian

Abstract

We propose an algorithm to model contagion in the interbank market via what we term the credit quality channel. In existing models on contagion via interbank credit, external shocks to banks often spread to other banks only in case of a default. In contrast, shocks are transmitted via asset devaluations and deteriorations in the credit quality in our algorithm: First, the probability of default (PD) of those banks directly affected by some shock increases. This increases the expected loss of the credit portfolios of the initially affected banks' counterparties, thereby reducing the counterparties' regulatory capital ratio. From a logistic regression, we estimate the increase in the counterparties' PD due to a reduced capital ratio. Their increased PDs in turn affect the counterparties' counterparties, and so on. This coherent and flexible framework is applied to bilateral interbank credit exposure of the entire German banking system in order to examine policy questions. For that purpose, we propose to measure the potential cost of contagion of a given shock scenario by the aggregated regulatory capital loss computed in our algorithm.

Suggested Citation

  • Fink, Kilian & Krüger, Ulrich & Meller, Barbara & Wong, Lui-Hsian, 2015. "The credit quality channel: Modeling contagion in the interbank market," Discussion Papers 38/2015, Deutsche Bundesbank.
  • Handle: RePEc:zbw:bubdps:382015
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    References listed on IDEAS

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    Cited by:

    1. Jager, Maximilian & Siemsen, Thomas & Vilsmeier, Johannes, 2020. "Interbank risk assessment: A simulation approach," Discussion Papers 23/2020, Deutsche Bundesbank.
    2. Leventides, John & Loukaki, Kalliopi & Papavassiliou, Vassilios G., 2019. "Simulating financial contagion dynamics in random interbank networks," Journal of Economic Behavior & Organization, Elsevier, vol. 158(C), pages 500-525.
    3. Bank for International Settlements, 2018. "Structural changes in banking after the crisis," CGFS Papers, Bank for International Settlements, number 60, Autumn.
    4. Bank for International Settlements, 2016. "Experiences with the ex ante appraisal of macroprudential instruments," CGFS Papers, Bank for International Settlements, number 56, Autumn.
    5. Pierre L. Siklos & Martin Stefan, 2020. "Exchange rate shocks in multicurrency interbank markets," CQE Working Papers 9220, Center for Quantitative Economics (CQE), University of Muenster.
    6. Jiang, Shanshan & Fan, Hong, 2021. "Systemic risk in the interbank market with overlapping portfolios and cross-ownership of the subordinated debts," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 562(C).
    7. Bardoscia, Marco & Barucca, Paolo & Codd, Adam Brinley & Hill, John, 2019. "Forward-looking solvency contagion," Journal of Economic Dynamics and Control, Elsevier, vol. 108(C).
    8. Silva, Walmir & Kimura, Herbert & Sobreiro, Vinicius Amorim, 2017. "An analysis of the literature on systemic financial risk: A survey," Journal of Financial Stability, Elsevier, vol. 28(C), pages 91-114.

    More about this item

    Keywords

    contagion; systemic risk; macroprudential policy; policy evaluation; interconnectedness;

    JEL classification:

    • C63 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computational Techniques
    • G01 - Financial Economics - - General - - - Financial Crises
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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