Interconnected banks and systemically important exposures

Abstract

We study the impact of the interplay between the structure of the financial network and market conditions on financial stability in the European banking system. We capture two channels of financial contagion. The first channel concerns direct interconnectedness, via a network of interbank loans, banks’ loans to other corporate and retail clients, and securities holdings. The second channel concerns indirect interconnectedness, via overlapping exposures to common asset classes. To assess the impact of contagion, we apply the structural valuation model NEVA, in which common shocks to banks’ external assets are reflected in a consistent way in the market value of banks’ mutual liabilities through the network of obligations. Applying the model to a unique supervisory data set collected by the European Central Bank that covers 26 large banks in the euro area we identify a strongly non-linear relationship between diversification of exposures, shock size, and losses due to interbank contagion. We also demonstrate the potential for contagion effects to amplify first-round stress test results due to interconnectedness. Finally, we provide insights into the potential impact of more diversified versus more domestic portfolio allocation strategies on the propagation of contagion, which are relevant to policy discussions about international risk sharing, for instance, in the context of the EU Capital Market Union.