Distress and default contagion in financial networks

Abstract

We develop a new model for solvency contagion that can be used to quantify systemic risk in stress tests of financial networks. In contrast to many existing models, it allows for the spread of contagion already before the point of default and hence can account for contagion due to distress and mark‐to‐market losses. We derive general ordering results for outcome measures of stress tests that enable us to compare different contagion mechanisms. We use these results to study the sensitivity of the new contagion mechanism with respect to its model parameters and to compare it to existing models in the literature. When applying the new model to data from the European Banking Authority, we find that the risk from distress contagion is strongly dependent on the anticipated recovery rate. For low recovery rates, the high additional losses caused by bankruptcy dominate the overall stress test results. For high recovery rates, however, we observe a strong sensitivity of the stress test outcomes with respect to the model parameters determining the magnitude of distress contagion.

A Continuous-Time Model of Financial Clearing

“…Still, what our model highlights is that a restructuring of a system of mutual obligations might lead to another, simpler system, which is equivalent in terms of the ultimate clearing vector. Veraart (2020) use a network model to describe how contagions, including distress contagions, which precede, rather than follow, an institution's bankruptcy, spread through the system. Elliott, Golub and Jackson (2014) analyze the role of integration and diversification in prevention of cascade failures.…”

S-shaped transition trajectory and dynamic development frontier of the financial systemic risk research: a multiple networks analysis

“…After applying the method to the European bank's dataset, they found that the perturbation of relative liabilities may lead to huge economic differences, which may underestimate the risk of infection. Banerjee andFeinstein (2019), Feinstein (2019), Veraart (2020), and Barucca et al (2020) explored financial systemic risk from the aspect of interdependent liabilities, a multilayered financial network, stress testing, and credit risk, respectively.…”

“…That shows that the third part of the global keyroute main path not only indicates the mainstream research direction in the last three years but also is an essential link in exploring the development trajectory of financial systemic risk research. In the last three years, scholars have focussed their attention on contagion (Feinstein et al, 2018), interdependent liabilities (Banerjee & Feinstein, 2019), a multilayered financial network (Feinstein, 2019), stress testing (Veraart, 2020), and credit risk (Barucca et al, 2020). By analysing these four main paths, we track the development trajectory of the financial systemic risk research, identify critical scholars who have influenced the development of the research field, and investigate recent core research directions in the research field.…”

Interbank Clearing in Financial Networks with Multiple Maturities

“…Since in many extensions the uniqueness of clearing solutions is lost, this interpretation is particularly interesting in the systemic risk context as different solutions can be given meaningful interpretation in terms of alternative valuations. Veraart (2017) follows this approach and investigates the effect of pre-default contagion, i.e., contagion that can be triggered prior to the actual default event due to distress and mark-to-market losses. The notions of distress and time-dependent valuation are also developed in Barucca et al (2016).…”