ECB Paper on Interconnected Banks and Systemically Important Exposures

The paper studies 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, the authors analyzed unique supervisory data set collected by ECB that covers 26 large banks in the euro area. To assess the impact of contagion, the authors applied Network Valuation or NEVA model, 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. Finally, the authors 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 Markets Union.

The key findings can be summarized as follows:

• The authors found a substantial portfolio overlap on banks’ exposures to the financial sector. 
• Measuring the impact of an exogenous shock by the number of defaults allows us to empirically support the theoretical results that more diversified interlinkages mitigate contagion risk for small perturbations in the system but may lead to higher contagion for larger shocks. Specifically, it has been found that an internationally diversified network of exposures is more resilient than a more domestic one for small shocks but less resilient for large shocks.
• The role of the financial network architecture for risk mitigation or amplification is ambiguous. Some configurations of financial contracts seem to increase financial stability. However, this happens at a cost for external creditors of the banks who would cover losses not absorbed by the banking system.
• Under a stress scenario of EBA designed for the 2016 EU-wide stress-test exercise first and second round contagion losses are comparable in size, although there is some heterogeneity across banks. In other words, the financial contagion channel—which tends to be ignored in supervisory stress tests—may have a non-negligible impact on banks’ solvency.
• The measure of the leverage overlap is highly correlated with the outcomes of the fully-fledged contagion analysis based on the NEVA methodology. Therefore, the authors derived a lower bound for losses based on leverage overlap which is an accurate indicator of systemic risk stemming from overlapping portfolios of banks.

These findings have important policy implications. First, when assessing risks from interconnectedness only focusing on direct intra-financial assets and liabilities, while ignoring more indirect contagion channels (such as common exposures) and underestimating the true contagion potential of systemic institutions. Second, there is value added to conducting macro-prudential stress tests incorporating contagion spillovers due to interconnectedness to complement findings of banking sector resilience drawn from traditional supervisory stress tests. Third, there is not one optimal network structure and there is a clear trade-off between financial diversification and the size of shocks hitting the system.

Related Link: Working Paper (PDF)

Keywords: Europe, EU, Banking, Systemic Risk, Stress Testing, Interbank Contagion, Capital Markets Union, NEVA Model, Contagion Risk, EBA, ECB