Interconnectedness and contagion risk in the European banking sector

As part of the research on financial stability carried out at the Banque de France, a tool has been developed to analyse the effect of the financial interconnections between European banking groups on contagion risk. This model makes it possible to assess the resilience of the European banking sector as a whole, as well as the bank-level characteristics that make a single bank more “vulnerable” to contagion or more “systemic” for its counterparties. Overall, we find that the estimated impact of contagion is highly heterogeneous across simulations, depending on the identity of the defaulting bank and the interbank network structure at the time the default occurs. For example, in 2008, for an average stress scenario, the default of the most systemic bank, after contagion effects, would have caused losses equal to about 13% of the Common Equity Tier 1 (CET1) capital of the banking system. For a few extreme cases, however, the losses would have reached up to 30% of the financial system’s capital (i.e. aabout EUR 300 billion) and triggered the default of 14 other institutions. While sizeable factors of vulnerability have persisted for some countries over the 2009-2012 period, the results indicate that over time the European banking system has become more resilient to contagion risk arising from interbank exposures.