UC Santa Barbara

In this work we present a simulation study to show that a shock in a common asset can be very impactful to default contagion, and we extend some analytic concepts to this scenario with common assets. We use an inhomogeneous random graph to represent the banking network, and, based on the possible exposures between banks, we define a minimum amount of capital each bank must hold in order to make the system stable to a shock that affects only a few banks. Then, we consider the case when a shock hits all banks at the same time, making them weaker and some of them initially in default. We analyze the final fraction of banks in default and compare it with other cases when the shock hits only a small proportion of banks. We show that a common shock can cause severe damage to the system.