Assessing interbank contagion using simulated networks

This paper presents a new approach to randomly generate interbank networks while overcoming shortcomings in the availability of bank-by-bank bilateral exposures. Our model can be used to simulate and assess interbank contagion effects on banking sector soundness and resilience. We find a strongly non-linear pattern across the distribution of simulated networks, whereby only for a small percentage of networks the impact of interbank contagion will substantially reduce average solvency of the system. In the vast majority of the simulated networks the system-wide contagion effects are largely negligible. The approach furthermore enables to form a view about the most systemic banks in the system in terms of the banks whose failure would have the most detrimental contagion effects on the system as a whole. Finally, as the simulation of the network structures is computationally very costly, we also propose a simplified measure - a so-called Systemic Probability Index (SPI) - that also captures the likelihood of contagion from the failure of a given bank to honour its interbank payment obligations but at the same time is less costly to compute. We find that the SPI is broadly consistent with the results from the simulated network structures. JEL Classification: E6