Abstract

Systemic liquidity risk, defined by the International Monetary Fund as “the risk of simultaneous liquidity difficulties at multiple financial institutions,” is a key topic in financial stability studies and macroprudential policy-making. In this context, the complex web of interconnections of the interbank market plays the crucial role of allowing funding liquidity shortages to propagate between financial institutions. Here, we introduce a simple yet effective model of the interbank market in which liquidity shortages propagate through an epidemic-like contagion mechanism on the network of interbank loans. The model is defined by using aggregate balance sheet information of European banks, and it exploits country and bank-specific risk features to account for the heterogeneity of financial institutions. Moreover, in order to obtain the European-wide topology of the interbank network, we define a block reconstruction method based on the exchange flows between the various countries. We show that the proposed contagion model is able to estimate systemic liquidity risk across different years and countries. Results suggest that our effective contagion approach can be successfully used as a viable alternative to more realistic but complicated models, which not only require more specific balance sheet variables with high time resolution but also need assumptions on how banks respond to liquidity shocks.

Highlights

  • The global financial crisis of 2007/08 has shown how fundamental is the role of liquidity risk in the stability of the financial system

  • For the sake of readability, we report in the main text only plots related to two representative years, 2007 and 2012

  • We proposed a stochastic epidemic-like model for the propagation of liquidity risk in the European interbank market

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Summary

Introduction

The global financial crisis of 2007/08 has shown how fundamental is the role of liquidity risk in the stability of the financial system. Our model only requires aggregated balance sheet exposure data, which are extracted for a set of European banks from the Bankscope dataset (Battiston et al 2016) As another difference from previous attempts, we have modeled the interbank network at the European level using a block structure, with each community representing the internal market of a country and intra-community relations representing cross-border claims. We remark that our framework is to all effects an effective model, based on i) a simplification of liquidity shocks dynamics using a contagion process, and ii) an ensemble representation of the underlying interbank network Both these ingredients require only aggregate balance sheet information, as well as a few model assumptions and parameters, to, e.g., the approaches by Eisenberg and Noe (2001) and Battiston et al (2012) that deal with solvency contagion.

Liquidity contagion model
Bankscope balance sheets
Bloomberg bid–ask spreads
BIS cross-border claims
Network reconstruction
Constrained maximum entropy and fitness model
Block reconstruction
Results
Reconstructed network
Contagion setting
Contagion without node variable
Contagion with node variable
Contagion and bankruptcy rates with node variable
Contagion and bankruptcy rates with node variable and confidence dynamics
Conclusions
Full Text
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