Do Side Effects Really Matter in Financial Contagion? An International Bank-Sovereign Simulation

Abstract

During the recent financial crisis the linkages between banks, public finances and the real economy were one of the important issues. The feedback and cross effects have shown their importance, and evidenced the need for more complete models that include circular feedbacks, cross linkages and side effects.In this paper we have developed a comprehensive simulation model for testing if these “secondary” effects have a relevant impact on the system, so that a more holistic approach can lead to more effective evaluations. The model includes some connecting aspects, as like indirect correlation and contagion between banks and public finances, and their sensitivity of both to the real economy variations.For verifying if results are model sensitive, the simulations are performed according to two different models. Results show that neglecting these indirect effects is misleading, and substantially underestimates the crisis effects.