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Distress and default contagion in financial networks

Veraart, Luitgard A. M. (2019) Distress and default contagion in financial networks. Mathematical Finance. ISSN 0960-1627 (In Press)

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Abstract

We develop a new model for solvency contagion that can be used to quantify systemic risk in stress tests of financial networks. In contrast to many existing models it allows for the spread of contagion already before the point of default and hence can account for contagion due to distress and mark-to-market losses. We derive general ordering results for outcome measures of stress tests that enable us to compare different contagion mechanisms. We use these results to study the sensitivity of the new contagion mechanism with respect to its model parameters and to compare it to existing models in the literature. When applying the new model to data from the European Banking Authority we find that the risk from distress contagion is strongly dependent on the anticipated recovery rate. For low recovery rates the high additional losses caused by bankruptcy dominate the overall stress test results. For high recovery rates, however, we observe a strong sensitivity of the stress test outcomes with respect to the model parameters determining the magnitude of distress contagion

Item Type: Article
Official URL: https://www.wiley.com/en-gb/Mathematical+Finance-p...
Divisions: Mathematics
Subjects: H Social Sciences > HB Economic Theory
J Political Science > JA Political science (General)
Q Science > QA Mathematics
JEL classification: C - Mathematical and Quantitative Methods > C6 - Mathematical Methods and Programming > C62 - Existence and Stability Conditions of Equilibrium
D - Microeconomics > D8 - Information, Knowledge, and Uncertainty > D85 - Network Formation and Analysis: Theory
G - Financial Economics > G2 - Financial Institutions and Services > G21 - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
G - Financial Economics > G2 - Financial Institutions and Services > G28 - Government Policy and Regulation
G - Financial Economics > G3 - Corporate Finance and Governance > G33 - Bankruptcy; Liquidation
Date Deposited: 07 Oct 2019 15:30
Last Modified: 26 Mar 2020 00:13
URI: http://eprints.lse.ac.uk/id/eprint/101905

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