Abstract:The global banking system proved signifi cantly vulnerable to systemic risk during the 2007-2009 fi nancial crisis. In this paper, we construct an agent-based network model of systemic risk to a banking system, and use it for stress-testing of several different regulatory measures. First, our simulations confi rm that suffi cient capital buffers in individual banks are crucial for protecting the stability of the whole system. Second, we show that the regulatory measures installed as preventive measures to ensure that the banks possess suffi cient capital buffers have almost no positive effects on stability when the system is collapsing. Finally, we highlight various data defi ciencies which prevent the researchers and regulators from fully understanding the complete range of systemic risk and make it diffi cult to devise effective and targeted regulatory measures at this time.

In this paper, we use an agent-based simulation combined with innovative calibration techniques to model the European banking system as accurately as possible. Our novel contribution to the recent literature involves adding bank heterogeneity to the model. To estimate the levels of shock propagation in large-scale events, such as the default of multiple banks, as well as smaller events, such as the defaults of an individual bank, we provide granular modeling of bank behavior. We extend the existing network approach by adding the ability to model banks of various sizes and the detailed connections of 286 individual banks across 9 European countries. Our main results show how the failure of a large Italian bank or of a medium-sized German bank might create a cascade of problems for the entire European banking sector. Our results reveal that Italian banks make a much larger contribution to systemic risk than German or French banks. We believe that computational experiments in this model provide valuable insights into systemic risk within the European banking system for policy makers when estimating the systemic effects of individual bank defaults. From a regulatory perspective, we recommend the introduction of a tighter limit for all types of inter-bank exposures than the recent limit of 25% of Tier 1 capital. Moreover, we propose an increase in the risk-weights for exposures to large banks in Germany, France, Italy, and Spain.

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