Forward-looking solvency contagion

Solvency contagion risk is a key channel through which systemic risk can come about. We introduce a model that accounts not only for losses transmitted after banks default, but also for losses due to the fact that creditors revalue their exposures when probabilities of default of their counterparties change. We apply the model to run a series of simplified stress tests of the UK banking system from 2008 to 2016, based on two datasets of real interbank exposures between the seven major UK banks. We show that risks due to solvency contagion decrease markedly from the peak of the crisis, to the point of becoming negligible. We also characterise the distributions of both vulnerabilities and systemic importances of individual banks, thereby tracking the evolution of risk concentration.