Externalities in interbank network: results from a dynamic simulation model

In this paper we conduct a simulation run on a sample of Italian banks where a trigger shock, a one-off event fairly large in size, spreads through the interbank network in a set-up featuring among the actors both commercial banks and the authorities. The banks deleverage to comply with a regulatory capital (leverage) ratio, roll off interbank loans, bid for central bank liquidity, seek help within their own group and dispose of assets. As the shock spreads, borrowers who lack liquid assets may be forced to undertake fire sales, letting their capital position deteriorate. A vicious circle arises in which capital and liquidity risks amplify the crisis. When authorities intervene, unconventional monetary policies smooth the contagion over but these measures become less effective when the shock is very large, when the situation is best addressed by policies aiming at strengthening banks� capital. In a theoretical scenario, in which authorities do not enact specific measures, a small fraction of the banking system (in terms of total assets) may be in default at the end of the simulation, while a larger share of banks would need to be recapitalized.