BoE paper maps contagion via CDS market

Economists identify mechanism whereby declining creditworthiness can spill from one bank to another via credit default swaps
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The Bank of England. Photo: Shutterstock

A team of economists has designed a network model where the creditworthiness of one bank impacts others via the credit default swap (CDS) market. Their results were published in a Bank of England (BoE) staff working paper on January 20.

Michalis Vasios of the BoE, Filip Zikes of the Federal Reserve, and Alan Morrison and Mungo Wilson of Oxford University use their mechanism to study contagion in a banking system.

If bank A has bought protection from bank B against the default of firm X, when B's creditworthiness declines that reduces the value of the protection, increases A's exposure to X, and thereby worsens bank A's creditworthiness as well.

The authors identify small levels of contagion even in "relatively benign" markets. They find banks' CDS exposure tends to be small, but the effects are both statistically significant and "economically real".

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