contagion

Topics: Bank, Asset, Bank run Pages: 23 (9609 words) Published: April 28, 2014
European Economic Review 48 (2004) 827 – 849
www.elsevier.com/locate/econbase

Estimating bilateral exposures in the German
interbank market: Is there a danger of contagion?
Christian Upper, Andreas Worms∗
Deutsche Bundesbank, Economics Department, Wilhelm-Epstein-Str. 14, D-60431 Frankfurt am Main, Germany
Received 9 September 2003; accepted 20 December 2003

Abstract
Credit risk associated with interbank lending may lead to domino e ects, where the failure of one bank results in the failure of other banks not directly a ected by the initial shock. Recent work in economic theory shows that this risk of contagion depends on the precise pattern of interbank linkages. We use balance sheet information to estimate a matrix of bilateral credit relationships for the German banking system and test whether the breakdown of a single bank can lead to contagion. We ÿnd that in the absence of a safety net, there is considerable scope for contagion that could a ect a large proportion of the banking system. The ÿnancial safety net (in this case institutional guarantees for saving banks and cooperative banks) considerably reduces—but does not eliminate—the danger of contagion. Even so, the failure of a single bank could lead to the breakdown of up to 15% of the banking system in terms of assets. c 2003 Elsevier B.V. All rights reserved.

JEL classiÿcation: G21; G28
Keywords: Contagion; Interbank market; Regulation of banks

1. Introduction
Credit risk associated with interbank lending may lead to domino e ects, where the failure of a bank results in the failure of other banks even if the latter are not directly a ected by the initial shock. Recent work in economic theory shows that this risk of contagion depends on the precise pattern of interbank linkages. For example, in the model of Allen and Gale (2000) banks hold deposits with banks of other regions in ∗

Corresponding author. Tel.: +49-69-9566-2398/3721; fax: +49-69-9566-3082. E-mail addresses: christian.upper@bundesbank.de (C. Upper), andreas.worms@bundesbank.de (A. Worms).
0014-2921/$ - see front matter c 2003 Elsevier B.V. All rights reserved. doi:10.1016/j.euroecorev.2003.12.009

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C. Upper, A. Worms / European Economic Review 48 (2004) 827 – 849

bank A

bank B

bank D

bank C

Fig. 1. ‘Complete market structure’ according to Allen and Gale (2000).

bank A

bank B

bank D

bank C

Fig. 2. ‘Incomplete market structure’ according to Allen and Gale (2000).

order to insure against liquidity shocks in their own region. Here a ‘region’ should not necessarily be interpreted in geographical terms but could, in principle, refer to any grouping of banks. If a bank is hit by a shock, it tries to meet its liquidity need by drawing on its deposits at other banks before liquidating long-term assets. This pecking order follows from the assumption that the premature liquidation of long-dated assets is costly, for example, because otherwise proÿtable real investment projects would have to be abandoned or long-term lending relationships interrupted. On the aggregate, the interbank market can only redistribute liquidity but does not create liquidity of its own. While this may not be a problem if the overall liquidity need is lower than the total holdings of liquid assets, it may give rise to contagion if the opposite is true. Instead of liquidating their long-term assets in response to a liquidity shock, banks withdraw their deposits at other banks, thus spreading the liquidity shortage throughout the ÿnancial system. The possibility of contagion depends strongly on the precise structure of interbank claims. Contagion is less likely to occur in what Allen and Gale term a ‘complete structure of claims’, in which every bank has symmetric linkages with all other banks in the economy (see Fig. 1). ‘Incomplete structures’, where banks have links only to a few neighbouring institutions (see Fig. 2 for an extreme example), are shown to be much more...
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