Measuring systemic risk and contagion in the European financial network

TL;DR

This paper presents a comprehensive framework combining risk indicators, network analysis, and a novel latent space model to assess systemic risk and contagion in the European financial network over time.

Contribution

It introduces a new latent space model and an integrated approach to analyze systemic risk, contagion, and network topology in European banks during financial crises.

Findings

Identifies key institutions contributing to systemic risk.

Visualizes contagion pathways and default dependencies.

Provides a dynamic, interpretable map of financial network health.

Abstract

This paper introduces a novel framework to study default dependence and systemic risk in a financial network that evolves over time. We analyse several indicators of risk, and develop a new latent space model to assess the health of key European banks before, during, and after the recent financial crises. First, we adopt the measure of CoRisk to determine the impact of such crises on the financial network. Then, we use minimum spanning trees to analyse the correlation structure and the centrality of the various banks. Finally, we propose a new statistical model that permits a latent space visualisation of the financial system. This provides a clear and interpretable model-based summary of the interaction data, and it gives a new perspective on the topology structure of the network. Crucially, the methodology provides a new approach to assess and understand the systemic risk associated with a financial system, and to study how debt may spread between institutions. Our dynamic framework provides an interpretable map that illustrates the default dependencies between institutions, highlighting the possible patterns of contagion and the institutions that may pose systemic threats.