Simulations of Financial Contagion in Interbank Networks: Some Methodological Issues

This contribution focuses on the methodology applied in papers that investigate the dynamics of contagion in financial networks using numerical simulations. In these papers, a propagation of losses and defaults in a financial system is modeled as a direct balance-sheet contagion (a.k.a. counterparty contagion), that is the direct transmission of losses from financially distressed debtors to their creditors. The researchers in this field perform their simulations with three different methods: (i) basic linear threshold algorithms, (ii) the graph-theoretic approach, where contagion is modeled as a propagation process in directed and weighted graphs, (iii) the lattice-theoretic approach, where contagion is modeled as a ‘fictitious default algorithm’, that computes the vector of payments that clears a net of financial obligations. Some of the results obtained by this stream of literature raised doubts about the assumptions used in such simulations. We discuss this issue and present some methodological recommendations that may improve the realism and the generality achievable in numerical investigations of financial contagion.