Measuring contagion risk in international banking
Focus
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. At the same time, the increased interconnectedness and complexity of the global banking system have made that task extremely challenging.
Contribution
We propose a novel methodology for measuring contagion risk in international banking. Our proposed methodology combines information contained in market prices (ie credit default swap (CDS) spreads) with information contained in banks' bilateral (country-level) foreign exposures. We use the rich dimensionality of the BIS international banking statistics to map the financial links among a set of 23 countries into a multi-layer network. The network maps the bilateral foreign claims of each country in three layers, which correspond to foreign claims on (i) the banking sector, (ii) the official sector and (iii) the non-bank private sector.
Findings
Our empirical analysis suggests that the measure generated using our novel methodology predicts CDS spreads better than an alternative measure based on past values of CDS spreads. This is the case, especially during crisis times, when the non-linear network effects tend to be more important.
Abstract
We propose a distress measure for national banking systems that incorporates not only banks' 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, we develop a new network centrality measure that can be interpreted in terms of a banking system's credit risk or funding risk.
JEL classification: G01, C58, C63
Keywords: international banking, contagion risk, multi-layer networks, tensor decompositions
