Contagion, Not Only Interconnection: Measuring the Transmission of Financial Distress

Abstract

This paper proposes a novel approach to understand contagion of financial distress in the banking system, which takes into account the spatial nature of the phenomena. We use a Bayesian spatial autoregressive model that treats the likelihood of default of each bank as endogenous, and dependent on the network formed by all the other banks. Identification is achieved by controlling for bank fundamentals, latent macrofinancial and bank specific shocks that have similar consequences to contagion and act as confounding factors. Through the lens of a simulations exercise we study the importance of the structure of financial networks for financial stability, shedding light on the empirical adherence of important theoretical propositions that remain untested.

Keywords: Financial Contagion, Financial Distress, Probability of Default, Bayesian Methods.

JEL Classification: E44, G01, C11, G21.