Systemic losses due to counterparty risk in a stylized banking system

Annika Birch and Tomaso Aste

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: We report a study of a stylized banking cascade model investigating systemic risk caused by counterparty failure using liabilities and assets to define banks' balance sheet. In our stylized system, banks can be in two states: normally operating or distressed and the state of a bank changes from normally operating to distressed whenever its liabilities are larger than the banks' assets. The banks are connected through an interbank lending network and, whenever a bank is distressed, its creditor cannot expect the loan from the distressed bank to be repaid, potentially becoming distressed themselves. We solve the problem analytically for a homogeneous system and test the robustness and generality of the results with simulations of more complex systems. We investigate the parameter space and the corresponding distribution of operating banks mapping the conditions under which the whole system is stable or unstable. This allows us to determine how financial stability of a banking system is influenced by regulatory decisions, such as leverage; we discuss the effect of central bank actions, such as quantitative easing and we determine the cost of rescuing a distressed banking system using re-capitalisation. Finally, we estimate the stability of the UK and US banking systems comparing the years 2007 and 2012 by using real data.

Keywords: banking crisis; counterparty risk; random field ising model; systemic risk (search for similar items in EconPapers)
JEL-codes: N0 (search for similar items in EconPapers)
Date: 2014-09
New Economics Papers: this item is included in nep-ban and nep-rmg
References: Add references at CitEc
Citations: View citations in EconPapers (7)

Published in Journal of Statistical Physics, September, 2014, 156(5), pp. 998-1024. ISSN: 0022-4715

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