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Interconnections among financial institutions create potential channels for contagionand amplification of shocks to the financial system. Contagion occurs when a shock tothe assets of a single firm causes other firms to default through the network of obligations.We say that contagion is weak if the...
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| Format: | Working paper |
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University of Oxford
2013
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| Summary: | Interconnections among financial institutions create potential channels for contagionand amplification of shocks to the financial system. Contagion occurs when a shock tothe assets of a single firm causes other firms to default through the network of obligations.We say that contagion is weak if the probability of default through contagion is no greaterthan the probability of default through independent direct shocks to the defaulting nodes.We derive a general formula which shows that, for a wide variety of shock distributions,contagion is weak unless the triggering node is very large and/or highly leveraged comparedto the nodes it topples through contagion. We derive our results in the Eisenberg-Noe(2001) framework with the addition of stochastic shocks. A distinguishing feature of ourapproach is that our conditions do not depend on the topology of interconnections: theyhold for any financial network with a given distribution of bank sizes and leverage levels.The likelihood of contagion increases when one augments the model to include bankruptcycosts and mark-to-market losses from credit quality deterioration. |
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