Insights into European interbank network contagion

Abstract

Purpose: – The purpose of this paper is to analyse the importance of interbank connections and shocks on banks’ capital ratios to financial stability by looking at a network comprising a large number of European and UK banks. Design/methodology/approach: – The authors model interbank contagion using insights from the Susceptible Infected Recovered model. The authors construct scale-free networks with preferential attachment and growth, applying simulated interbank data to capture the size and scale of connections in the network. The authors proceed to shock these networks per country and perform Monte Carlo simulations to calculate mean total losses and duration of infection. Finally, the authors examine the effects of contagion in terms of Core Tier 1 Capital Ratios for the affected banking systems. Findings: – The authors find that shocks in smaller banking systems may cause smaller overall losses but tend to persist longer, leading to important policy implications for crisis containment. Originality/value: – The authors infer the interbank domestic and cross-border exposures of banks employing an iterative proportional fitting procedure, called the RAS algorithm. The authors use an extend sample of 169 European banks, that also captures effects on the UK as well as the Eurozone interbank markets. Finally, the authors provide evidence of the contagion effect on each bank by allowing heterogeneity. The authors compare the bank’s relative financial strength with the contagion effect which is modelled by the number and the volume of bilateral connections.