The credit quality channel: Modeling contagion in the interbank market
•Shocks via the credit quality channel are caused and transmitted not only by bank defaults but already by a deterioration of credit quality and a devaluation of banks’ assets.•We find that contagion risk is concentrated around four of the 1710 German banks.•When a SIFI defaults, losses from indirec...
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| Published in: | Journal of financial stability Vol. 25; pp. 83 - 97 |
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| Main Authors: | , , , |
| Format: | Journal Article |
| Language: | English |
| Published: |
Elsevier B.V
01-08-2016
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| Subjects: | |
| Online Access: | Get full text |
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| Summary: | •Shocks via the credit quality channel are caused and transmitted not only by bank defaults but already by a deterioration of credit quality and a devaluation of banks’ assets.•We find that contagion risk is concentrated around four of the 1710 German banks.•When a SIFI defaults, losses from indirect credit exposure are much higher than from direct exposure.•We find that a shock to the mortgage sector hits banks via write-downs to their own portfolio and, equally hard, via the losses of their counterparties.
We propose an algorithm to model contagion in the interbank market via what we term the “credit quality channel”. In existing models on contagion via interbank credit, external shocks to banks often spread to other banks only in case of a default. In contrast, shocks are transmitted also via asset devaluations and deteriorations in the credit quality in our algorithm. First, the probability of default (PD) of those banks directly affected by some shock increases. This increases the expected loss of the credit portfolios of the initially affected banks’ counterparties, thereby reducing the counterparties’ regulatory capital ratio. From a logistic regression we estimate the increase in the counterparties’ PD due to a reduced capital ratio. Their increased PDs in turn affect the counterparties’ counterparties, and so on. This coherent and flexible framework is applied to the bilateral interbank credit exposure of the entire German banking system in order to examine policy questions. For that purpose, we propose to measure the potential cost of contagion of a given shock scenario by the aggregated regulatory capital loss computed in our algorithm. |
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| ISSN: | 1572-3089 1878-0962 |
| DOI: | 10.1016/j.jfs.2016.06.002 |