Credit Contagion between Financial Systems

Abstract

Abstract:We examine contagion from a number of financial systems to the German financial system using the information content of CDS prices in a GARCH model. After controlling for common factors which may cause comovement in security prices, we find evidence for contagion from the US and European financial systems. Our results additionally confirm that the set up of the financial rescue scheme in Germany partially shielded German banks but not insurance companies from contagion. Overall, our results suggest that contagion from dealer banks have the most prominent effect on the German financial system. While dealer banks impact on German banks and insurance companies in a similar way, a deterioration in the CDS spreads of dealer banks has a particularly pronounced effect on German dealer banks. Keywords:Systemic Risk, CDS Spreads, Contagion, OTC Dealer JEL-Classification: G14, G21, G28 Non-technical summaryThe global financial crises has led to a marked rise in the awareness of the importance of systemic risk. More specifically, the crisis has demonstrated that systemic events can rapidly spill over across borders and to markets, gathering strength and augmenting systemic risk. The vulnerability of financial institutions to contagious effects has placed this issue on top of the agenda of financial stability regulation.In this paper, we examine contagion effects emanating from the financial systems of the US, Europe, Asia-Pacific region and emerging markets to the German financial system using the information content of CDS prices. The structure of OTC markets makes this market and the dealer banks particularly vulnerable to contagion. This is largely due to the high concentration of trading among a few dealers and to the opaqueness of the market. For this reason, we specifically examine the strength of contagion from dealer banks to the German financial system, distinguishing between banks and insurance companies. In addition we explore the magnitude of contagion over time. The relevance of the dynamic nature of contagion was demonstrated during the financial crisis, which started in the US housing market but peaked when a number of individual institutions became distressed. We thus investigate changes in the strength of these financial systems' interdependence. To achieve this we consider, inter alia, the impact of the default of Lehman Brothers and the financial stabilization scheme set up in Germany. To address all these objectives, we use weighted CDS spread indices for each financial system. Our reliance on broad indices allows us to obtain a comprehensive view of the risk to the German financial system. Our findings suggest that there are strong contagious effects from the US and Europe and no effects from the Asia-Pacific region and emerging markets on the the German financial system. While the magnitude of contagion from the US and Europe to the German financial system is comparable, contagion from the US only affects the level of risk in the German financial system, while contagion from the European fina...

Model risk on credit risk

“…Intuitively, the Dandelion model mimics the relationship between a bank and its many borrowers, or even between a Central Bank with the rest of the economy, see [25].…”

Risk Exposures and Financial Spillovers in Tranquil and Crisis Times: Bank-Level Evidence

“…Instead, there is evidence of contagion from French to U.K. banks, Italian to Dutch banks, German to Spanish banks, U.K. to Spanish banks, and bilateral contagion between Germany and Italy. Podlich and Wedow (2011) examine spillovers to and from Germany to other countries regions using weighted CDS spread indices in a GARCH model. The study finds evidence of contagion from the U.S. and European banking systems to the German banking system, and no effects from Asia and emerging countries.…”