Assessing financial contagion in the interbank market: Maximum entropy versus observed interbank lending patterns

Paolo Emilio Mistrulli

No 641, Temi di discussione (Economic working papers) from Bank of Italy, Economic Research and International Relations Area

Abstract: Interbank markets allow banks to cope with specific liquidity shocks. At the same time, they may be a channel allowing a bank default to spread to other banks. This paper analyzes how contagion propagates within the Italian interbank market using a unique data set including actual bilateral exposures. Since information on bilateral exposures was not available in most previous studies, they assumed that banks spread their lending as evenly as possible among all the other banks by maximizing the entropy of interbank linkages. Based on the data available on actual bilateral exposures for all Italian banks, the results obtained by assuming the maximum entropy are compared with those reflecting the observed structure of interbank claims. The comparison indicates that, in line with the thesis prevailing in the literature, the maximum entropy method tends to underestimate the extent of contagion. However, this does not hold in general. Under certain circumstances, depending on the structure of the interbank linkages, the recovery rates of interbank exposures and banks� capitalization, the maximum entropy approach overestimates the scope for contagion.

Keywords: interbank market; financial contagion; systemic risk; maximum entropy (search for similar items in EconPapers)
JEL-codes: G21 G28 (search for similar items in EconPapers)
Date: 2007-09
New Economics Papers: this item is included in nep-ban, nep-cfn and nep-fmk
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (78)

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Journal Article: Assessing financial contagion in the interbank market: Maximum entropy versus observed interbank lending patterns (2011)
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