The credit quality channel: Modeling contagion in the interbank market |
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Institution: | 1. Deutsche Bundesbank, Germany;2. European Central Bank, Germany;1. Fundação Getulio Vargas–EAESP, Av. Nove de Julho 2029, Bela Vista, 01313-902, Sao Paulo, SP, Brazil;2. Depep, Banco Central do Brasil and Fundação Escola de Comércio Álvares Penteado (Fecap), Brazil;1. Manchester Accounting and Finance Group, University of Manchester, Booth Street West, Manchester M15 6PB, UK;2. Management School, University of Liverpool, Chatham Building, Liverpool L69 7ZH, UK;3. Centre for Research in Economics and Finance, Cranfield School of Management, Cranfield University, MK43 0AL, UK;1. Bank for International Settlements, Switzerland;2. European Central Bank, Germany;1. School of Economics and Business Administration, University of Navarra, Edificio Amigos, 31009 Pamplona, Spain;2. BBVA Research, Paseo Castellana 81, 7th Floor, 28046 Madrid, Spain |
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Abstract: | We propose an algorithm to model contagion in the interbank market via what we term the “credit quality channel”. In existing models on contagion via interbank credit, external shocks to banks often spread to other banks only in case of a default. In contrast, shocks are transmitted also via asset devaluations and deteriorations in the credit quality in our algorithm. First, the probability of default (PD) of those banks directly affected by some shock increases. This increases the expected loss of the credit portfolios of the initially affected banks’ counterparties, thereby reducing the counterparties’ regulatory capital ratio. From a logistic regression we estimate the increase in the counterparties’ PD due to a reduced capital ratio. Their increased PDs in turn affect the counterparties’ counterparties, and so on. This coherent and flexible framework is applied to the bilateral interbank credit exposure of the entire German banking system in order to examine policy questions. For that purpose, we propose to measure the potential cost of contagion of a given shock scenario by the aggregated regulatory capital loss computed in our algorithm. |
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Keywords: | Contagion Systemic risk Macroprudential policy Policy evaluation Interconnectedness |
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