This paper presents a novel approach to investigate and model the network of euro area banks’ large exposures within the global banking system. Drawing on a unique dataset, the paper, for the first time, documents the degree of interconnectedness and systemic risk of the euro area banking system based on bilateral linkages. We then develop a Contagion Mapping (CoMap) methodology to study contagion potential of an exogenous default shock via counterparty credit and funding risks. We construct contagion and vulnerability indices measuring respectively the systemic importance of banks and their degree of fragility. Decomposing the results into the respective contributions of credit and funding shocks provides insights to the nature of contagion which can be used to calibrate bank-specific capital and liquidity requirements and large exposures limits. We empirically confirm that tipping points shifting the euro area banking system from a less vulnerable state to a highly vulnerable state are a non-linear function of the combination of network structures and bank-specific characteristics.

This paper shows how the combined endogenous reaction of banks and investment funds to an exogenous shock can amplify or dampen losses to the financial system compared to results from single-sector stress testing models. We build a new model of contagion propagation using a very large and granular data set for the euro area. Based on the economic shock caused by the Covid-19 outbreak, we model three sources of exogenous shocks: a default shock, a market shock and a redemption shock. Our contagion mechanism operates through a dual channel of liquidity and solvency risk. Our analysis reveals that adding the fund sector to our model for banks leads to additional losses through fire sales and a further depletion of banks’ capital ratios by around one percentage point. The main driver of additional bank losses are endogenous market losses generated by investment funds’ asset liquidation.