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BSLoss a comprehensive measure for interconnectedness

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Co-authors: Kilian Fink (Deutsche Bundesbank), Ulrich Krueger (Deutsche Bundesbank), Lui-Hsian Wong (Deutsche Bundesbank)

We propose a measure for interconnectedness: BSLoss, the banking system loss which describes the increase in expected credit losses due to contagion risk. For this purpose, we construct an algorithm to model the transmission of credit risk in the interbank market via a multiple-round-process. Core to the algorithm is the simulation of how a deterioration of credit quality of debtor banks spills over to creditor banks via the interbank credit channel. The transmission of an exogenous shock to one or a group of banks is modeled on the basis of the empirical relationship between the Tier 1 capital ratio and the probability of default of banks. As a consequence of the contagion mechanism a devaluation of banks assets and an increase in credit losses can be observed. Compared to other measures for interconnectedness BSLoss comprises several merits: It is easy to interpret in economic terms (ie expressible in monetary units) and reacts sensitively even to small changes in cr edit risk (ie reflects a market value approach). The algorithm may be applied to analyze the effectiveness of systemic capital buffers to curb contagion risk in the banking system.

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