Interconnected banks and systemically important exposures

Abstract

We study the interplay between two channels of interconnectedness in the banking system. The first one is a direct interconnectedness, via a network of interbank loans, banks' loans to other corporate and retail clients, and securities holdings. The second channel is an indirect interconnectedness, via exposures to common asset classes. To this end, we analyze a unique supervisory data set collected by the European Central Bank that covers 26 large banks in the euro area. To assess the impact of contagion, we apply a structural valuation model NEVA (Barucca et al., 2016a), in which common shocks to banks' external assets are reflected in a consistent way in the market value of banks' mutual liabilities through the network of obligations. We identify a strongly non-linear relationship between diversification of exposures, shock size, and losses due to interbank contagion. Moreover, the most systemically important sectors tend to be the households and the financial sectors of larger countries because of their size and position in the financial network. Finally, we provide policy insights into the potential impact of more diversified versus more domestic portfolio allocation strategies on the propagation of contagion, which are relevant to the policy discussion on the European Capital Market Union.

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“…The higher the bank interconnectedness ratio, the more likely that a shock to bank's external assets or liabilities will have systemic repercussions (i.e., will not stay with just one bank, but will be transferred also to other banks in the system). The lower the interconnectedness ratio, i.e., the more diversified banks' portfolios, the lower the likelihood and the strength of the propagation of contagion (Roncoroni et al, 2019). We suppose that an increase in the bank interconnectedness ratio will have a positive effect on credit growth, on house price growth, and on the amplitude of the deviations of the actual economic growth rate from its long-run trend, thereby undermining financial stability.…”

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