A simulation approach to distinguish risk contribution roles to systemic crises

The last financial crisis has shown that large banking crises pose a highly dangerous risk to both the real economy and public finances. Reducing that risk has become a priority for regulators and governments, but the debate on how to deal with it remains open. Contagion plays a key role: domino effects can turn a relatively small difficulty into a systemic crisis. It is thus important to assess how contagion spreads across banking systems and how to distinguish the two roles played by ‘lighters’ and ‘fuel’ in the crisis, i.e. which banks are likely to start financial contagion and which have a ‘passive’ role in just being driven to default by contagion. The aim of this paper is to propose a methodology for distinguishing the two roles, and for assessing their different contributions to systemic crises. For this purpose, we have adapted a Monte Carlo simulation-based approach for banking systems which models both correlation and contagion between banks. Selecting large crises in simulations, and finding which banks started each simulated crisis, allows us to distinguish ‘primary’ and ‘induced’ defaults and fragility, and to determine the contribution of individual banks to the triggering of systemic crises.