Contagion effects from a shock to sovereign debt holdings in an interconnected network system (2013)

Undergraduate: Conor Howells

Faculty Advisor: Jeremy Petranka
Department: Economics

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The recent European Sovereign Debt Crisis has illustrated that the extent to which contagion will spread across interconnected networks is unknown. This paper examines the impact of a negative shock to the value of a sovereign¿s debt as collateral on the Interbank Lending Market (ILN) and also on collateral of other countries within a system defined by financial but not fiscal integration. This is accomplished by defining theoretical interconnected centrality measures for multiple networks based on the Katz-Bonacich centrality measure. These centrality measures are used to express the optimal quantities for all banks in a Cournot equilibrium within the ILN. The paper finds that a negative shock to the sovereign debt of a country will impact all banks within the ILN and that the extent of the shock on a bank¿s optimal quantity is determined by the relative change in it¿s debt centrality compared to it¿s relative centrality within the ILN. It is concluded that the change in profit levels for banks will determine how much other countries will be affected by the initial shock to the interconnected network system.