Interbank Exposures: Quantifying the Risk of Contagion

Abstract

Interbank Exposures:Quantifying the Risk of Contagion Craig H. Furfine (bio) Abstract This paper examines the degree to which the failure of one bank would cause the subsequent collapse of other banks. Using unique data on interbank payment flows, the magnitude of bilateral federal funds exposures is quantified. These exposures are used to simulate the impact of various failure scenarios, and the risk of contagion is found to be economically small. This paper quantifies contagion risk present in the U.S. banking system. Unlike previous studies that infer contagion indirectly by identifying common characteristics of banks that are affected by some event (e.g., third-world debt crisis, large bank failure), this study estimates contagion directly by examining data containing the complete universe of federal funds transactions across banks. Using such data allows for straightforward simulation exercises that demonstrate the degree of contagion that might arise from these exposures. The cost of this direct approach to measuring contagion is clear. The data analyzed only incorporate federal funds transactions. Because of severe data limitations, other exposures among banks cannot be examined on a bilateral basis. As a result of this, an obvious criticism of the results that follow is that other exposures may actually be much higher or may be distributed in a particularly contagion-enhancing way. While it will be argued that the federal funds exposures used in this paper make up a substantial fraction of unsecured interbank credit exposures, one must realize that the conclusions reached are conditional on the set of exposures being examined. That is, the estimates of contagion reported here are accurate, yet potentially conservative. Despite this caveat, the approach employed in this paper to measure contagion has at least three important advantages. First and foremost, the data measure exposures bilaterally. That is, each bank's exposure to every other bank is known. This [End Page 111] unique data feature allows not only direct measurement of the immediate impact of a particular bank failure, but also allows for the calculation of any secondary or knock-on failures that may subsequently arise. Second, the exposures used here are true credit exposures, as federal funds transactions represent unsecured lending between financial institutions. Thus, one does not need to be concerned that reported exposures differ from actual exposures because of collateral arrangements or other risk mitigating techniques. Third, the data are measured each day, allowing an explicit consideration of the possibility that exposures in banking can change dramatically and rapidly. Anticipating the results, the paper finds that federal funds exposures are neither large enough nor distributed in a way to cause a great risk of contagion. In fact, very few banks would fail as a direct result of the failure of an important federal funds borrower. Illiquidity, however, presents a greater threat to the banking system. Should the largest federal funds debtor become unable to borrow, it is simulated that illiquidity could spread to banks holding almost 9% of US banking system assets. The remainder of the paper is organized as follows. Section 1 contrasts the direct and indirect approach of estimating contagion and relates this distinction to different ways previous research has chosen to define systemic risk. A literature review is provided. Section 2 describes the bilateral federal funds data and translates these data into measures of potential interbank credit losses. Section 3 presents the results of various failure scenarios. The impact of a loss of liquidity is explored in Section 4. Section 5 provides the conclusions. 1. Two Definitions of Systemic Risk: Theory and Evidence Preventing the troubles of an individual or a small number of financial institutions from causing widespread disruption in financial markets or significant difficulty at otherwise viable institutions is widely perceived to be a crucial element of a central bank's mission. It was primarily this concern that led the Federal Reserve Bank of New York to facilitate the private sector acquisition of a large stake in the hedge fund Long Term Capital Management (LTCM) when the latter experienced financial difficulty in 1998.1 Although LTCM was not a bank or otherwise supervised by the Federal Reserve, the U.S. central bank decided to proactively encourage an orderly process by which private sector...