Direct vs. Side Effects in Financial Contagion: What Weights More?
During the recent financial crisis the linkages between banks, public finances and the real economy were one of the important issues. The feedback and cross effects have shown their importance, and evidenced the need for more complete models that include circular feedbacks, cross linkages and side effects. In this paper we have developed a comprehensive simulation model for testing if these “secondary” effects have a relevant impact on the system, so that a more holistic approach can lead to more effective evaluations. The model includes indirect correlation and contagion between banks and public finances, and the sensitivity of both to the real economy variations. Results show that neglecting these indirect effects is misleading, and substantially underestimates the crisis effects. The method is tested on the main banking groups in the EBA panel.
KeywordsBanking risk Contagion Monte Carlo simulation Sovereign risk
- Acharya VV, Drechsler I, Schnabl P (2011) A phyrrhic victory? Bank Bailouts and Sovereign Credit Risk, CEPR Discussion Paper 8679Google Scholar
- Basel Committee on Banking Supervision (2010) The transmission channels between the financial and real sectors: a critical survey of the literature, Issue No. 27Google Scholar
- Bernoth K, Erdogan B (2010) Sovereign bond yield spreads: a time-varying coefficient approach. DIW, mimeoGoogle Scholar
- Bernoth K, von Hagen J, Schuknecht L (2004) Sovereign risk Premia in the European Government Bond Market. European Central Bank Working Paper Series No. 369Google Scholar
- Bikker JA, Hu H (2002) Cyclical patterns in profits, provisioning and lending of banks. DNB Staff Reports, No. 86, AmsterdamGoogle Scholar
- Cecchetti SG, Kohler M, Upper C (2009) Financial crises and economic activity, Working Paper, BISGoogle Scholar
- Demirguc-Kunt A, Huizinga H (2000). Financial structure and bank profitability. Policy Research Working Paper Series 2430. The World BankGoogle Scholar
- Edwards S (1986) The pricing of bonds and bank loans in international markets: an empirical analysis of developing countries’ foreign borrowing. NBER Working Paper No. 1689Google Scholar
- European Commission (2011) Directorate General for Economic and Financial Affairs, Public finances in EMU 2011. European Economy 3, 2011. Available at http://ec.europa.eu/economy_finance/publications/european_economy/2011/ee3_en.htm
- Galliani C, Zedda S (2014) Will the bail-in break the vicious circle between banks and their sovereign? Comput Econ. doi:10.1007/s10614-014-9436-9Google Scholar
- International Monetary Fund (2010) Global financial stability report. Sovereigns, Funding and Systemic Liquidity. World Economic and Financial Surveys, October, 2010. Available at http://www.imf.org/External/Pubs/FT/GFSR/2010/02/index.htm
- Lemmen J, Goodhart C (1999) Credit risk and European government bond markets: a panel data econometric analysis. Eastern Econ J 25:1Google Scholar