Distress and Default Contagion in Financial Networks
31 Pages Posted: 5 Sep 2017 Last revised: 22 Jun 2018
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Distress and Default Contagion in Financial Networks
Distress and Default Contagion in Financial Networks
Date Written: June 15, 2018
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 allow 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.
Keywords: Systemic risk, contagion, financial networks, stress testing
JEL Classification: C62, D85, G01, G21, G28, G33
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