Dynamic Contagion Risk
We develop a dynamic model of contagion in the interbank market with heterogenous banks. Bank fundamentals are subject to idiosyncratic and aggregate shocks, as well as contagion shocks. Contagion shocks are triggered across all banks when any bank's fundamentals fall below a (distance-to-default) threshold. We analytically characterise the limiting distriubtion of the model as a stochastic partial differential equation. Using panel data on the fundamentals of each bank in the U.S. banking sector from 1980 to 2025, this section develops and calibrates a dynamic contagion model to estimate and predict systemic contagion risks. We propose simulation risk measures based on the excess loss/probability of failure over a baseline without contagion effects. This historical experiment demonstrates the utility of the derived forward-looking contagion indicators for forecasting banking failures and contagion events.
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