A Study of Financial Contagion in Interbank System

Financial contagion was often observed during the recent financial crisis, which indicates a critical need for a new and fundamental understanding of its dynamics. Drawing analogies with the extinction analysis—a technique widely used in the study of ecosystems—we focus on modeling and analyzing the financial contagion in a system where a large number of financial institutions are randomly connected by direct balance sheet linkages owing to their lending or borrowing relationships. We propose a simple contagion algorithm to study the effect of several determinants, such as the topology of a financial network, exposure ratio, leverage ratio, and liquidation ratio. We find that the financial contagion weakens with the growth of a network's connectivity to some extent. Therefore, a financial system with higher connectivity is more stable or robust. We also find that the exposure ratio increases the risk of financial contagion, but both the leverage ratio and liquidation ratio have negative relationships with financial contagion.