Cascading Defaults and Systemic Risk of a Banking System

Abstract

Systemic risk of a banking system arises from cascading defaults due to interbank linkages. We propose a model which distinguishes systemic risk from its drivers -- systematic and idiosyncratic risks. Systemic risk is characterised by systemic exposure and systemic fragility, corresponding to the expected losses and pervasiveness of defaults respectively (under a stress scenario). The model takes into account the banking network, asset-liability dynamics, interbank exposures and netting. Using actual data for 15 British banks, we find that systematic shocks are more likely to drive systemic risk, as opposed to banks’ idiosyncratic elements. We also demonstrate a method for ranking banks according to systemic importance.