Endogenous distress contagion in a dynamic interbank model: how possible future losses may spell doom today

Zachary Feinstein and Andreas Sojmark

Papers from arXiv.org

Abstract: We introduce a dynamic and stochastic interbank model with an endogenous notion of distress contagion, arising from rational worries about future defaults and ensuing losses. This entails a mark-to-market valuation adjustment for interbank claims, leading to a forward-backward approach to the equilibrium dynamics whereby future default probabilities are needed to determine today's balance sheets. Distinct from earlier models, the resulting distress contagion acts, endogenously, as a stochastic volatility term that exhibits clustering and down-market spikes. Furthermore, by incorporating multiple maturities, we provide a novel framework for constructing systemic interbank term structures, reflecting the intertemporal risk of contagion. We present the analysis in two parts: first, the simpler single maturity setting that extends the classical interbank network literature and, then, the multiple maturity setting for which we can examine how systemic risk materialises in the shape of the resulting term structures.

Date: 2022-11, Revised 2025-02
New Economics Papers: this item is included in nep-ban and nep-net
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