Endogenous distress contagion in a dynamic interbank model: how possible future losses may spell doom today

TL;DR

This paper develops a dynamic stochastic interbank model where endogenous distress contagion influences systemic risk, incorporating future default worries into current valuations and creating a framework for systemic interbank term structures.

Contribution

It introduces a novel model with endogenous distress contagion and multiple maturities, extending classical interbank network models to capture systemic risk dynamics.

Findings

Distress contagion acts as stochastic volatility with clustering.

The model produces systemic interbank term structures.

Future default worries impact current balance sheets.

Abstract

We introduce a dynamic and stochastic interbank model with an endogenous notion of distress contagion, arising from rational worries about future defaults and ensuing losses. This entails a mark-to-market valuation adjustment for interbank claims, leading to a forward-backward approach to the equilibrium dynamics whereby future default probabilities are needed to determine today's balance sheets. Distinct from earlier models, the resulting distress contagion acts, endogenously, as a stochastic volatility term that exhibits clustering and down-market spikes. Furthermore, by incorporating multiple maturities, we provide a novel framework for constructing systemic interbank term structures, reflecting the intertemporal risk of contagion. We present the analysis in two parts: first, the simpler single maturity setting that extends the classical interbank network literature and, then, the multiple maturity setting for which we can examine how systemic risk materialises in the shape of the resulting term structures.