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

Zachary Feinstein and Andreas Sojmark

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

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 materializes in the shape of the resulting term structures.

Keywords: systemic risk; distress contagion; dynamic network model; multiple maturities; valuation adjustment; volatility effects; term structure; yield curves (search for similar items in EconPapers)
JEL-codes: C1 (search for similar items in EconPapers)
Pages: 25 pages
Date: 2026-02-23
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Published in Mathematical Finance, 23, February, 2026. ISSN: 0960-1627

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