BIS published a working paper on measuring contagion risk in international banking. In the paper, the authors propose a distress measure for national banking systems to incorporate not only banks’ credit default swap (CDS) spreads, but also how they interact with the rest of the global financial system via multiple linkage types. The measure is based on a tensor decomposition method that extracts an adjacency matrix from a multi-layer network, measured using banks’ foreign exposures obtained from the BIS international banking statistics. Based on this adjacency matrix, the authors develop a new network centrality measure that can be interpreted in terms of the credit risk or funding risk of a banking system.
The rapid growth of the global financial system over the past couple of decades has increased the importance of properly measuring contagion risk. This is true not only from a financial stability point of view, but also from a macroeconomic perspective, as financial crises tend to have significant and persistent negative effects on economic activity. Additionally, the increased interconnectedness and complexity of the global banking system have made that task extremely challenging. A novel methodology for measuring contagion risk in international banking has been proposed in the paper.
The empirical analysis suggests that the measure generated using the novel methodology predicts CDS spreads better than an alternative measure based on (unadjusted) past values of CDS spreads. This is the case, especially during crisis times, when the non-linear network effects tend to be more important. The methodology can be rather useful for policymakers, as it gives an early warning measure of a national banking system’s distress levels, which incorporates information on its foreign exposures. The measure can also be extended to any multi-layer financial network, such as an interbank network. Furthermore, the methodology that has been proposed could potentially be utilized in a bottom-up stress test. More precisely, the proposed methodology could generate estimates of the expected losses of an institution, while incorporating all relevant information on (direct and indirect) exposures, linkages, and contagion probabilities.
Related Link: Working Paper
Keywords: International, Banking, Securities, Contagion Risk, CDS, Credit Risk, Stress Testing, Research, Swaps, BIS
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