The Decline of Solvency Contagion Risk

We study solvency contagion risk in the UK banking system from 2008 to 2015. We develop a model that only accounts for losses transmitted after banks default, but also for losses due to the fact that creditors revalue their exposures when probabilities of default of their counterparties change. We apply our model to a unique data set of real UK interbank exposures. We show that risks due to solvency contagion decrease markedly from the peak of the crisis to the present, to the point of becoming negligible. By decomposing the change in losses into two main contributions — the increase in banks' capital and the decrease in interbank exposures — we are able to pinpoint the main driver in each year. In some cases we observe that an increase in aggregate capital is associated with a positive contribution to losses. This suggests that the distribution of capital among banks is also important