Assessing Financial Contagion in the Interbank Market: Maximum Entropy Versus Observed Interbank Lending Patterns

Abstract

Interbank markets allow banks to cope with specific liquidity shocks. At the same time, they may represent a channel for contagion as a bank default may spread to other banks through interbank linkages. This paper analyses how contagion propagates within the Italian interbank market using a unique data set including actual bilateral exposures. Since information about bilateral exposures was not available in most of the previous works, they assumed that banks spread their lending as evenly as possible among all the other banks by maximizing the entropy of interbank linkages. Based on the availability of information on actual bilateral exposures for all Italian banks, the results obtained by assuming the maximum entropy are compared with those reflecting the observed structure of interbank claims. The comparison indicates that, in line with the thesis prevailing in the literature, the maximum entropy method tends to underrate the extent of contagion. However, this does not hold in general. Under certain circumstances, depending on the structure of the interbank linkages, the recovery rates of interbank exposures and banks' capitalisation, the maximum entropy approach overrates the scope for contagion.