Transmission Channels of Systemic Risk and Contagion in the European Financial Network

Abstract

We investigate systemic risk and how financial contagion propagates within the euro area banking system by employing the Maximum Entropy method. The study captures multiple snapshots of a dynamic financial network and uses counterfactual simulations to propagate shocks emerging from three sources of systemic risk: interbank, asset price, and sovereign credit risk markets. As conditions deteriorate, these channels trigger severe direct and indirect losses and cascades of defaults, whilst the dominance of the sovereign credit risk channel amplifies, as the primary source of financial contagion in the banking network. Systemic risk within the northern euro area banking system is less apparent, while the southern euro area banking system is more prone and susceptible to bank failures provoked by financial contagion. By modelling the contagion path the results demonstrate that the euro area banking system insists to be markedly vulnerable and conducive to systemic risks.