Credit Risk Spillovers, Systemic Importance and Vulnerability in Financial Networks

Abstract

How does the change in the creditworthiness of a financial institution or sovereign impact its creditors solvency? I address this question in the context of the recent European sovereign debt crisis. Considering the network of Eurozone member states, interlinked through investment cross-holdings, I model default as a multi-stage disease with each credit-rating corresponding to a new infection phase, then derive systemic importance and vulnerability indicators in the presence of financial contagion, triggered by the change in the creditworthiness of a network member. I further extend the model to analyse not only negative, but also positive credit risk spillovers.

Keywords: financial networks, systemic risk, contagion, multi-stage disease

JEL Classification: F34, G01, G15