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Journal ArticleDOI

Interconnected banks and systemically important exposures

01 Dec 2021-Journal of Economic Dynamics and Control (Bank of Canada)-Vol. 133, pp 104266

Abstract: How do banks' interconnections in the euro area contribute to the vulnerability of the banking system? We study both the direct interconnections (banks lend to each other) and the indirect interconnections (banks are exposed to similar sectors of the economy). These complex linkages make the banking system more vulnerable to contagion risks.
Topics: Vulnerability (52%)

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Bank of Canada staff working papers provide a forum for staff to publish work-in-progress research independently from the Bank’s Governing
Council. This research may support or challenge prevailing policy orthodoxy. Therefore, the views expressed in this paper are solely those of the
authors and may differ from official Bank of Canada views. No responsibility for them should be attributed to the Bank.
www.bank-banque-canada.ca
Staff Working Paper / Document de travail du personnel 2019-44
Interconnected Banks and
Systemically Important Exposures
by Alan Roncoroni, Stefano Battiston, Marco D’Errico, Grzegorz Halaj,
and Christoffer Kok

ISSN 1701-9397 © 2019 Bank of Canada
Bank of Canada Staff Working Paper 2019-44
November 2019
Interconnected Banks and Systemically Important
Exposures
by
Alan Roncoroni
1
, Stefano Battiston
2
, Marco D'Errico
3
, Grzegorz Halaj
3
, and
Christoffer Kok
4
1
Department of Banking and Finance
University of Zurich
Switzerland
2
European Systemic Risk Board
Frankfurt
3
Financial Stability Department
Bank of Canada
Ottawa, Ontario, Canada K1A 0G9
GHalaj@bank-banque-canada.ca
4
European Central Bank
Frankfurt

i
Acknowledgements
Stefano Battiston acknowledges support from the FET Project DOLFINS no. 640772. Alan
Roncoroni, Stefano Battiston and Marco D'Errico acknowledge financial support from the
Swiss National Science Foundation Professorship, grant no. PP00P1-144689. Alan
Roncoroni and Stefano Battiston acknowledge the support from the program on Macro-
economic Efficiency and Stability of the Institute for New Economic Thinking (INET).
The authors would also like to acknowledge the participants in the FINEXUS 2018
Conference on financial networks and sustainability at the University of Zurich, the Joint
Banco de Portugal/ESRB Workshop 2018, the Bank of Canada internal seminar, the
European Commission JRC 1st Conference in Brussels, the Canadian Economic
Association Conference 2019, and the FSB/IMF Workshop on Financial
Interconnectedness and Systemic Stress Simulation in Washington for their comments. In
particular, the authors are grateful to anonymous referees, Paolo Barucca, Seisaku Kameda,
Ricardo Sousa, Joseph Stiglitz, Virginie Traclet, Maarten van Oordt and Jan Werner for
fruitful discussions and feedback on early versions of this work. The views expressed are
those of the authors and do not necessarily represent those of the European Central Bank,
the ESRB, the Eurosystem, or the Bank of Canada.

ii
Abstract
We study the interplay between two channels of interconnectedness in the banking system.
The first one is a direct interconnectedness, via a network of interbank loans, banks' loans
to other corporate and retail clients, and securities holdings. The second channel is an
indirect interconnectedness, via exposures to common asset classes. To this end, we
analyze a unique supervisory data set collected by the European Central Bank that covers
26 large banks in the euro area. To assess the impact of contagion, we apply a structural
valuation model NEVA (Barucca et al., 2016a), in which common shocks to banks' external
assets are reflected in a consistent way in the market value of banks' mutual liabilities
through the network of obligations. We identify a strongly non-linear relationship between
diversification of exposures, shock size, and losses due to interbank contagion. Moreover,
the most systemically important sectors tend to be the households and the financial sectors
of larger countries because of their size and position in the financial network. Finally, we
provide policy insights into the potential impact of more diversified versus more domestic
portfolio allocation strategies on the propagation of contagion, which are relevant to the
policy discussion on the European Capital Market Union.
Bank topic: Financial stability
JEL codes: C63, G15, G21

1 Introduction
The financial system is characterized by a wide range of interconnections that can, in various ways,
give rise to contagion effects with potentially pernicious implications for financial stability. While
direct contagion through, for instance, bilateral links between banks and other financial institutions
have long been recognized as an obvious transmission channel, more indirect contagion effects through,
for instance, banks’ common exposures to similar economic sectors are gaining increasing attention
as a potentially more potent channel of contagion (Clerc et al., 2016). This paper studies systemic
risk arising both from direct interbank contagion effects and from indirect contagion through portfolio
overlaps across economic sectors.
Risks related to asset portfolio overlaps, or, in other words, asset commonality or similarity in
business models, have been studied from a theoretical perspective and were assessed as a relevant
source of potential contagion losses in the financial system. Risks related to portfolio overlaps are
part of the so-called indirect channel of contagion.
1
So far, the empirical analysis has been conducted
either for some isolated sectors of the economy, e.g. Duarte and Eisenbach (2013), Ha laj et al. (2015),
Cont and Schaanning (2018) or using broader aggregates of exposures, e.g. Ha laj (2018). However, a
systematic analysis of the importance of economic sectors in combination with the country of
residence of the obligor is missing.
In order to fill this gap, we propose a new methodology to measure the systemic importance
of country sectors throughout the banking systems in monetary terms. We account for
both the first-round and second-round losses through the interbank exposures according to
a generalized model of contagion. Moreover, we explain the mechanics of different contagion patterns
based on the underlying matrix of exposures of banks’ portfolios across countries and sectors. Within
this framework, different patterns of contagion and different patterns of overlaps can be discerned.
We apply our methodology to a unique supervisory data set covering 26 of the largest banks
in the euro area along with their exposures to detailed sectors of the real economy (broken down at
the level of one-digit NACE
2
code) and to other financial institutions.
Other studies have proposed alternative composite systemic risk measures based on network data
(see e.g. the Systemic Risk Index by Cont et al. (2013), the Systemic Probability Index by Ha laj and
Kok (2013) or the Indirect Contagion Index by Cont and Schaanning (2018)). These other measures
try to capture individual banks’ risk exposure due to interconnectedness in relation to the banks’
buffers against this risk, measured by their capital or counter-balancing capacity of liquid assets.
In the same spirit, we propose a measure that straightforwardly combines overlapping exposures
1
See e.g. Cifuentes et al. (2005), Caccioli et al. (2014), Cont and Wagalath (2014), Cont and Schaanning (2018).
2
NACE is derived from the French Nomenclature statistique des activit´es ´economiques dans la Communaut´e
europ´eenne.
1

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Citations
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Abstract: We develop a method to analyze the effects on financial stability of the interplay between climate policy shocks and market conditions. We combine the frameworks of the Climate Stress-test with the framework of the network valuation of financial assets, in which the valuation of interbank claims accounts for market volatility as well as for endogenous recovery rates consistent with the network of obligations. We also include the dynamics of common asset contagion involving not only banks but also investment funds, which are key players in the low carbon transition. We then apply the model to a unique supervisory data-set of banks and investment funds at the firm level in order to assess the impact for financial stability of shocks deriving from the disorderly alignment of energy and utility sectors in a range of climate policy scenarios. While under mild shock scenarios systemic losses are contained, we identify the climate policy scenarios and market conditions under which systemic losses can pose a threat to financial stability.

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Cites background or methods from "Interconnected banks and systemical..."

  • ...For a more exhaustive derivation of the valuation function, including the case when σ = 0, see Roncoroni et al. (2018)....

    [...]

  • ...This approach has been applied to supervisory data in (Roncoroni et al., 2018)....

    [...]

  • ...Indeed, a high recovery rate coefficient and a low asset price volatility lead to lower level of amplification losses in the contagion process (Roncoroni et al., 2018)....

    [...]

  • ...…on the Eisenberg and Noe (2001) model, on the DebtRank model (Battiston et al., 2012; Bardoscia et al., 2015) and its extensions or applications (Poledna et al., 2015; Poledna and Thurner, 2016; Bardoscia et al., 2017b,a), and the NEVA model (Roncoroni et al., 2018; Barucca et al., 2020)....

    [...]

  • ...Following Battiston et al. (2016); 5https://www.iea.org/statistics/monthly/#electricity Roncoroni et al. (2018), they can be expressed as follows: Ξ1stmpit = min { 0 , ∑ c ∑ s min {0 , Ωm,p,c,s,t} ·Aloansi,c,s,t } = (7) = min { 0 , ∑ c ∑ s min {0 , (1− rj)χumpcst} ·Aloansi,c,s,t } , (8) where: the…...

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Posted ContentDOI
01 Jan 2020
Abstract: Due to the international dimension of the financial sector within the EU and beyond, domestically oriented macroprudential policies have the potential to create material cross-border spillover effects This occasional paper provides a detailed overview of the academic and empirical literature on cross-border effects of macroprudential policies It also summarises a stocktaking exercise, conducted by a task force of the ESCB’s Financial Stability Committee (FSC), on existing national approaches within the EU for assessing and monitoring such cross-border spillover effects The paper accompanies an FSC report presenting a framework to be used by macroprudential authorities when assessing cross-border spillover effects induced by enacted or planned policy measures JEL Classification: E42, E58, F36, G21

11 citations


Cites background from "Interconnected banks and systemical..."

  • ...…2013; D’Errico et al., 2017), via common exposures due to overlapping portfolios (Caccioli et al., 2012; Hałaj et al., 2015; Montagna and Kok, 2016; Roncoroni et al., 2019) or via other indirect channels such as through information contagion, correlation and behavioural commonalities (see…...

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Abstract: We analyze the effects on financial stability of the interplay between climate transition risk and market conditions, such as recovery rate and asset price volatility. To this end, we extend the framework of the climate stress-test of the financial system by including an ex-ante network valuation of financial assets which accounts for asset price volatility as well as for endogenous recovery rate on interbank assets. Moreover, we also consider the dynamics of indirect contagion of banks and investment funds, which are key players in the low carbon transition, via exposures to the same asset classes. We derive some analytical results and we apply the model to a unique supervisory dataset in a range of climate policy scenarios and market conditions. In the event of a disorderly low-carbon transition, stronger market conditions allow to reach more ambitious climate policies at the same level of financial risk.

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Posted ContentDOI
Abstract: In this paper we present a methodology of model-based calibration of additional capital needed in an interconnected financial system to minimize potential contagion losses. Building on ideas from combinatorial optimization tailored to controlling contagion in case of complete information about an interbank network, we augment the model with three plausible types of fire sale mechanisms. We then demonstrate the power of the methodology on the euro area banking system based on a network of 373 banks. On the basis of an exogenous shock leading to defaults of some banks in the network, we find that the contagion losses and the policy authority's ability to control them depend on the assumed fire sale mechanism and the fiscal budget constraint that may or may not restrain the policy authorities from infusing money to halt the contagion. The modelling framework could be used both as a crisis management tool to help inform decisions on capital/liquidity infusions in the context of resolutions and precautionary recapitalisations or as a crisis prevention tool to help calibrate capital buffer requirements to address systemic risks due to interconnectedness.

5 citations


Cites background from "Interconnected banks and systemical..."

  • ...…between financial institutions might have a stabilization property due to more diverse transferring of risk, it has been proven that this may only be the case up to a certain magnitude of shocks hitting the financial system (Acemoglu, Ozdaglar, and Tahbaz-Salehi 2015b; Roncoroni et al. 2019)....

    [...]

  • ...ECB Working Paper Series No 2554 / May 2021 10 the similarity of overlapping portfolios subject to fire sales, see e.g Roncoroni et al. (2019) and Aldasoro, Hüser, and Kok (2020) for recent applications of portfolio overlaps....

    [...]


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Abstract: Presented at the American Finance Association Meeting, New York, December 1973.(This abstract was borrowed from another version of this item.)

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Gabriel Gasque1, Stephen Conway1, Juan Huang2, Yi Rao3  +2 moreInstitutions (4)
TL;DR: This work used Drosophila melanogaster larvae to develop a high-throughput whole organism screen for drugs that modulate food intake and identified the serotonin (5-hydroxytryptamine or 5-HT) receptor antagonist metitepine as a potent anorectic drug.
Abstract: Dysregulation of eating behavior can lead to obesity, which affects 10% of the adult population worldwide and accounts for nearly 3 million deaths every year. Despite this burden on society, we currently lack effective pharmacological treatment options to regulate appetite. We used Drosophila melanogaster larvae to develop a high-throughput whole organism screen for drugs that modulate food intake. In a screen of 3630 small molecules, we identified the serotonin (5-hydroxytryptamine or 5-HT) receptor antagonist metitepine as a potent anorectic drug. Using cell-based assays we show that metitepine is an antagonist of all five Drosophila 5-HT receptors. We screened fly mutants for each of these receptors and found that serotonin receptor 5-HT2A is the sole molecular target for feeding inhibition by metitepine. These results highlight the conservation of molecular mechanisms controlling appetite and provide a method for unbiased whole-organism drug screens to identify novel drugs and molecular pathways modulating food intake.

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Larry Eisenberg, Thomas H. Noe1Institutions (1)
TL;DR: An algorithm is developed that both clears the financial system in a computationally efficient fashion and provides information on the systemic risk faced by the individual system firms and produces qualitative comparative statics for financial systems.
Abstract: We consider default by firms that are part of a single clearing mechanism. The obligations of all firms within the system are determined simultaneously in a fashion consistent with the priority of debt claims and the limited liability of equity. We first show, via a fixed-point argument, that there always exists a "clearing payment vector" that clears the obligations of the members of the clearing system; under mild regularity conditions, this clearing vector is unique. Next, we develop an algorithm that both clears the financial system in a computationally efficient fashion and provides information on the systemic risk faced by the individual system firms. Finally, we produce qualitative comparative statics for financial systems. These comparative statics imply that, in contrast to single-firm results, even unsystematic, nondissipative shocks to the system will lower the total value of the system and may lower the value of the equity of some of the individual system firms.

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Daron Acemoglu1, Daron Acemoglu2, Daron Acemoglu3, Asuman Ozdaglar1  +2 moreInstitutions (4)
Abstract: We provide a framework for studying the relationship between the financial network architecture and the likelihood of systemic failures due to contagion of counterparty risk. We show that financial contagion exhibits a form of phase transition as interbank connections increase: as long as the magnitude and the number of negative shocks affecting financial institutions are sufficiently small, more "complete" interbank claims enhance the stability of the system. However, beyond a certain point, such interconnections start to serve as a mechanism for propagation of shocks and lead to a more fragile financial system. We also show that, under natural contracting assumptions, financial networks that emerge in equilibrium may be socially inefficient due to the presence of a network externality: even though banks take the effects of their lending, risk-taking and failure on their immediate creditors into account, they do not internalize the consequences of their actions on the rest of the network.

1,009 citations


"Interconnected banks and systemical..." refers background or result in this paper

  • ...The relevance of market structures is for instance highlighted by the well-known result of Wagner (2011) and Acemoglu et al. (2015), which we are able to replicate in our detailed empirical study: a more modular financial system is more fragile than a more diversified financial system to small shocks, while it is more robust to big shocks. Similar results on the impact of diversification on financial stability are discussed in Bardoscia et al. (2017), Silva et al. (2018) and Stiglitz (2018)....

    [...]

  • ...This result is in line with Acemoglu et al. (2015) and is explained by the fact that a domestic network has a more modular and fragmented structure that prevents the shocks from being easily spread across the system. In fact, in the domestic allocation where mainly domestic banks are responsible for the size of exposures for a given country and sector, the largest loss that can be propagated to other countries is equivalent to the liabilities of the banks in the shocked country. For this reason, the number of defaults does not increase after the shock reaches a threshold estimated at around 70%. On the other hand, in the diversified allocation of exposures, first-round losses are diluted among all banks; similarly second-round losses can affect all banks at the same time. This is why the number of defaults does not saturate and increases with the severity of the initial shock. Visentin et al. (2016) show that in the absence of frictions – i....

    [...]

  • ...The relevance of market structures is for instance highlighted by the well-known result of Wagner (2011) and Acemoglu et al. (2015), which we are able to replicate in our detailed empirical study: a more modular financial system is more fragile than a more diversified financial system to small shocks, while it is more robust to big shocks....

    [...]

  • ...This result is in line with Acemoglu et al. (2015) and is explained by the fact that a domestic network has a more modular and fragmented structure that prevents the shocks from being easily spread across the system....

    [...]

  • ...The relevance of market structures is for instance highlighted by the well-known result of Wagner (2011) and Acemoglu et al. (2015), which we are able to replicate in our detailed empirical study: a more modular financial system is more fragile than a more diversified financial system to small shocks, while it is more robust to big shocks. Similar results on the impact of diversification on financial stability are discussed in Bardoscia et al. (2017), Silva et al. (2018) and Stiglitz (2018). Additionally, we benchmark the severity of the stylized shock scenarios by conducting a contagion analysis instigated by loan losses generated under a consistent macro-financial scenario designed for the EU-wide 2016 European Banking Authority (EBA) stress-test exercise....

    [...]


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Prasanna Gai1, Andrew Haldane2, Sujit Kapadia2Institutions (2)
Abstract: This paper develops a network model of interbank lending in which unsecured claims, repo activity and shocks to the haircuts applied to collateral assume centre stage. We show how systemic liquidity crises of the kind associated with the interbank market collapse of 2007–2008 can arise within such a framework, with funding contagion spreading widely through the web of interlinkages. Our model illustrates how greater complexity and concentration in the financial network may amplify this fragility. The analysis suggests how a range of policy measures – including tougher liquidity regulation, macro-prudential policy, and surcharges for systemically important financial institutions – could make the financial system more resilient.

693 citations


"Interconnected banks and systemical..." refers background or methods or result in this paper

  • ...Suggested Citation: Roncoroni, Alan; Battiston, Stefano; D'Errico, Marco; Halaj, Grzegorz; Kok, Christoffer (2019) : Interconnected banks and systemically important exposures, Bank of Canada Staff Working Paper, No....

    [...]

  • ...Both are based on the simulated network approach of Ha laj and Kok (2013). In a nutshell, the simulated network procedure randomly samples interbank structures using a version of an accept-reject algorithm....

    [...]

  • ...Measuring the impact of an exogenous shock by the number of defaults allows us to empirically support the theoretical results of (Gai et al., 2011; Acemoglu et al., 2015; Silva et al., 2018) that more diversified interlinkages mitigate contagion risk for small perturbations in the system but may…...

    [...]

  • ...Measuring the impact of an exogenous shock by the number of defaults allows us to empirically support the theoretical results of Gai et al. (2011), Wagner (2011) and Acemoglu et al. (2015) that more diversified interlinkages mitigate contagion risk for small perturbations in the system but may lead…...

    [...]

  • ...Another example of a model that takes into account the interbank network effects on banks’ valuations, although a more simplified one, is proposed by Ha laj (2013)....

    [...]


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