Cross-border interbank networks, banking risk and contagion

• We study spillover risks in the cross-border interbank network.
• To do so, we use confidential data on bilateral links between banking systems.
• This allows estimating feedback effects among interlinked banking systems.
• We show that bilateral cross-border links in interbank markets affect stability.
• Interbank positions to more stable banking systems yield positive spillovers.

Recent events have highlighted the role of cross-border linkages between banking systems in transmitting local developments across national borders. This paper analyzes whether international linkages in interbank markets affect the stability of interconnected banking systems and channel financial distress within a network consisting of banking systems of the main advanced countries for the period 1994–2012. Methodologically, I use a spatial modeling approach to test for spillovers in cross-border interbank markets. The results suggest that foreign exposures in banking play a significant role in channeling banking risk: I find that countries that are linked through foreign borrowing or lending positions to more stable banking systems abroad are significantly affected by positive spillover effects. From a policy point of view, this implies that in stable times, linkages in the banking system can be beneficial, while they have to be taken with caution in times of financial turmoil affecting the whole system.