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Authors develop a contagion mapping methodology (CoMap) to study systemic risk stemming from interconnectedness based on the euro area Significant Institutions’ network of large exposures within the global banking system. On the basis of supervisory reporting of large bilateral exposures they construct the arguably most comprehensive todate euro area network of bilateral linkages and combine it with bank balance sheet information to capture bank-specific characteristics and related (regulatory) solvency and liquidity constraints.
The CoMap methodology estimates contagion potential due to credit and funding risks via bilateral linkages. The main objective is to assess the amount of losses and number of defaults an exogenous shock to a bank (or a group of banks) induces to the system. In achieving this, the CoMap methodology evaluates first round effects (direct losses) and subsequent round effects (cascade losses) due to domino defaults and potential fire sale losses.
Authors then develop contagion and vulnerability indexes capturing counterparty credit and funding risks of an exogenous default shock so as to rank banks in terms of contribution to euro area systemic risk and their degree of fragility, respectively. The outcome is a practical and quarterly updatable policy tool to map contagion risks stemming from within and outside the euro area banking system. Overall, the paper provides unique insights on the interplay of banks’ characteristics and the topology of the euro area interbank network.
Specifically, the methodology allows for taking a more granular, heterogeneous and holistic approach to the euro area banking system’s study of contagion risk. Thus, they model 199 consolidated banking groups (of which 90 from the euro area) in Q3-2017 tracking among them debt, equity, derivative and off-balance sheet exposures larger than 10% of a bank’s eligible capital. They then model banks’ heterogeneity by calibrating the model’s parameters using exposure-specific information on collateral pledged and maturity structure as well as bank-specific pool of HQLA and non-HQLA assets and capital requirements. Overall, the large exposures dataset covers on average 90% of euro area banks’ RWAs vis-à-vis credit institutions for a total amount of EUR 1.4 trillion and EUR 680 billion, respectively in gross and RWA terms.
Authors furthermore calculate the contribution of amplification effects (beyond the initial loss) to the overall losses induced by a bank’s default or distress (amplification ratio), and they derive a sacrifice ratio indicator assessing the cost-return trade off of a bank-bailout. Finally, they illustrate how their framework can be used to run counterfactual simulations showing how contagion risk can be reduced by fine-tuning prudential capital and liquidity measures.
Key findings highlight that the degree of bank-specific contagion and vulnerability depends on network specific tipping points affecting directly the magnitude of amplification effects. It follows that the identification of such tipping points and their determinants is the essence of an effective micro and macro prudential supervision. Moreover, they bring evidence that in isolation and with linear variations, bank-specific characteristics seem to play a less relevant role than the network structure, whereas what really matters comes from their non-linear interaction, for which both are equally important. In a variety of tests, heterogeneity in the magnitude of bilateral exposures and of bank-specific parameters is detected as a key driver of the total number of defaults in the system. Authors also show that international spillovers (also coming from non-euro area banks) are an important channel of contagion for the euro area financial system.
Overall, they think that the CoMap methodology combined with the large exposures dataset may help enhance understanding of how contagion within the euro area interbank network may propagate and be amplified by the actual heterogeneous characteristics of the agents and the topologic features of the network. It also provides a practical monitoring toolkit for the regular surveillance and assessment of contagion risk within the euro area interbank network.