Systemic losses due to counterparty risk in a stylized banking system (Q743444)

The authors report how interconnectedness via the interbank market and ratios between liabilities and assets influence the stability of a stylized banking system. In this system, banks can be in two states: normally operating or distressed and the state changes from normally operating to distressed whenever its liabilities are larger than the bank's assets. The banks are connected through an interbank lending network and, whenever a bank is distressed, its creditors cannot expect the loan from the distressed bank to be repaid, potentially becoming distressed themselves. The authors discuss a solution of the model obtained by homogenizing the system. Further, they test robustness and generality of the obtained mean-field solution. After that, the authors detail the parameter ranges that lead to a stable or unstable system. This allows them to determine restricting ratios between liabilities and assets to ensure a stable banking system. The costs of potential rescue attempts to re-direct an unstable system into a stable are quantified. Finally, an estimation of the stability of the UK and US banking systems is provided comparing the years 2007 and 2012 using real data.