Distress and Default Contagion in Financial Networks

35 Pages Posted: 16 Oct 2019

See all articles by Luitgard A. M. Veraart

Luitgard A. M. Veraart

London School of Economics & Political Science (LSE) - Department of Mathematics

Multiple version iconThere are 2 versions of this paper

Date Written: October 7, 2019

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.

Keywords: systemic risk, contagion, financial networks, stress testing, mark-to-market losses

JEL Classification: C62, D85, G01, G21, G28, G33

Suggested Citation

Veraart, Luitgard A. M., Distress and Default Contagion in Financial Networks (October 7, 2019). Available at SSRN: https://ssrn.com/abstract=3465612 or http://dx.doi.org/10.2139/ssrn.3465612

Luitgard A. M. Veraart (Contact Author)

London School of Economics & Political Science (LSE) - Department of Mathematics ( email )

Houghton Street
GB-London WC2A 2AE
United Kingdom

Register to save articles to
your library

Register

Paper statistics

Downloads
44
Abstract Views
152
PlumX Metrics