BoE: Banking sector interconnectedness: what is it, how can we measure it and why does it matter?

08 June 2015

This article explains the different ways in which banks can be interconnected, discusses how this can be measured and explores the implications for financial stability.

Banks can be directly and indirectly interconnected:

• Direct interconnectedness occurs via bilateral transactions or relationships, such as interbank loans. In such cases, the greater the degree of direct interconnectivity between banks, the greater the likelihood that a default by one bank could trigger contagion to other banks.
• Indirect interconnectedness between banks might arise in situations such as when a distressed bank makes ‘fire’ sales that lead to falls in asset prices and associated mark-to-market losses for other banks.

The article shows that while direct interconnectedness between banks from interbank credit exposures has declined since the crisis, indirect interconnectedness, as monitored by correlations in banks’ CDS premia, may have increased.

Since the financial crisis, a number of regulatory initiatives have been introduced to mitigate the financial stability risks posed by interconnectedness between banks. A key measure has been to oblige banks to clear all standardised over-the-counter (OTC) derivative contracts through central counterparties (CCPs). Though this has made banks more interconnected with CCPs, regulators are taking a number of actions to mitigate risks from this, including the introduction of resolution tools for CCPs.

In addition, authorities have tightened limits on direct exposures between systemically important financial institutions, while stress testing or macro-prudential tools can also tackle risks arising from direct and indirect interconnectedness. Furthermore, the Financial Policy Committee includes measures of bank interconnectedness in the set of core indicators it monitors regularly.

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