Identifying Contagion in a Banking Network

Abstract

This paper studies the impact of trading profits and losses on bank counterparty borrowing costs using data from a derivatives trade depositary. We use the network of credit default swap (CDS) transactions between banks to identify bank CDS returns attributable to counterparty losses. Any bank’s exposure to corporate default increases whenever counterparties from whom it has purchased default protection themselves experience losses. In line with this statement, we document an increase in the own CDS spread of such a bank. We find no such effect from losses of non-counterparties, nor from counterparties who have bought protection from, rather than sold protection to, the bank. We also find that the effect on bank CDS returns through this counterparty loss channel is large relative to the direct effect on a bank’s CDS returns from its own trading losses.