Transmission of distress in a bank credit network

TL;DR

This paper presents a simulation model to analyze how distress spreads among banks in a credit network, highlighting factors like network heterogeneity and capital buffers that influence default risks during financial crises.

Contribution

It introduces a novel simulation framework to quantify distress transmission in bank networks, considering heterogeneity and capital requirements.

Findings

Heterogeneity increases default risk propagation.

Higher equity capital ratios reduce bank defaults.

Capital surcharges on big banks mitigate systemic risk.

Abstract

The European sovereign debt crisis has impaired many European banks. The distress on the European banks may transmit worldwide, and result in a large-scale knock-on default of financial institutions. This study presents a computer simulation model to analyze the risk of insolvency of banks and defaults in a bank credit network. Simulation experiments reproduce the knock-on default, and quantify the impact which is imposed on the number of bank defaults by heterogeneity of the bank credit network, the equity capital ratio of banks, and the capital surcharge on big banks.