Financial Contagion: How Shocks Spread Through Interconnected Banks

What Financial Contagion Is

Financial contagion refers to the spread of distress or failure from one financial institution to another, often leading to a broader crisis. This phenomenon can be modeled using network theory and simulations like the 2D interbank network provided here.

The model helps us understand how interconnectedness among banks amplifies small shocks into large-scale failures.

How the Eisenberg-Noe Model Works

The Eisenberg-Noe (EN) model is a mathematical framework used to analyze the default cascade in interbank networks. It captures the idea that each bank’s solvency depends on its ability to settle debts with other banks.

In this 2D network, each bank node represents an institution, and edges represent interbank claims and liabilities.

Why Financial Contagion Matters

Financial contagion is crucial for understanding the stability of financial systems. It highlights the importance of regulatory oversight and risk management in preventing systemic failures.

The model demonstrates how even small shocks can lead to large-scale defaults, emphasizing the need for robust stress testing and early warning systems.

Real-World Examples

During the 2008 financial crisis, interbank contagion played a significant role in spreading the economic downturn from the U.S. to other countries.

The EN model has been used by central banks and financial regulators to assess the resilience of the banking system and design policies to mitigate potential risks.

Frequently asked questions

Try it live

Everything above runs in your browser — open Financial Contagion Network (2D) and change the parameters while it is running. Nothing is installed, nothing is uploaded, the whole model lives in one tab.