ESSAYS ON INTERBANK NETWORKS AND SYSTEMIC RISK IN THE EUROPEAN UNION BANKING SECTOR

The financial crisis of 2008-2009 and the subsequent EU sovereign debt crisis of 2010-2012 highlighted the vulnerability of the banking sector to contagious defaults, and so mainly due to the interconnectedness of banks through short-term and mostly unsecured interbank loans. Links created in the interbank markets are a potential channel for propagating contagion especially when banks default on their interbank financial obligations. In addition, banks' investments in correlated assets, the valuation of counterparty risk, and banks' diversification into non-traditional sources of revenue are potential channels amplifying contagion. This thesis, therefore, examines factors that contribute to systemic risk in the European Union banking sector. First, we investigate systemic risk and dynamics of contagion within the European Union interbank market using data on 168 to 249 commercial banks from 2011 to 2018. A copula approach is used to reconstruct the network. We then apply a duplex interbank network model to test the banks' sensitivity to capitalisation and interbank lending. We show that the European Union interbank market is robust in mitigating the propagation of contagious defaults from direct bilateral exposure. However, when banks’ liquidate their external assets, correlation in asset prices amplifies contagion, becoming a significant threat to the stability of the banking union. In addition, an increase in the banks’ capitalisation and a reduction in their engagement in interbank lending significantly reduce systemic risk. Next, we examine the impact of credit valuation on systemic risk using a sample of 112 to 238 commercial banks from 2005 to 2020. We reconstruct the EU interbank networks using a minimum density approach. We then test for the significance of credit valuation under a range of shock sizes and recovery rates, using a Network of Equity Valuation (NEVA) model. We find that credit valuation plays a significant role in the stability of the EU banking system. At lower levels of valuation, contagion is only evident when a significant shock hits the banking system. In contrast, as credit valuation increases, banks become sensitive to valuation such that they default even in the absence of shocks. We observe that, as more banks default in the first round, the amplification of contagious defaults reduces to a minimum. Finally, we investigate the role of income diversification on systemic risk contribution. We construct five market-based measures of systemic risk widely used by regulators using a common framework that allows for comparisons. Using an unbalanced panel of 101 publicly traded banks headquartered in the EU from 2000 to 2019, we find that non-interest income, bank size, loan loss provision, and leverage are significant contributors to systemic risk. In contrast, liquidity and banks’ charter size significantly reduce systemic risk. By decomposing non-interest income into its main components, we observe that commissions and fees and other non-interest income are the key drivers of systemic risk. When controlling for size, we find that other non-interest income, commissions and fees, and total assets are the main contributors to banks’ systemic risk for large, medium, and small banks, respectively. Overall, our findings suggest that measures such as increased capital requirements as proposed in Basel III and the enactment of the Bank Recovery and Resolution Directive (BRRD) have the potential to significantly enhance financial stability in the EU. Similarly, enhanced disclosure requirements for banks in relation to the reporting of credit value adjustments, as revised in the Pillar 3 framework of the Basel Committee, is a major step towards a more robust banking union. However, our results also suggest that bank managers, regulators, and policymakers may wish to remain mindful of other important factors, such as non-interest income, bank size, and loan loss provision, which we find may also have severe destabilising effects on the EU banking system