A simulation approach to evaluate systemic risk

•We illustrate the propagation of individual banks' default risk through the system.•We measure the likelihood of individual failures by rating transition probabilities.•Our model allows variations in size, risk, market share, rating and capital of banks.•We identify higher Tier 1 ratios as a major remedy against contagious effects.•Our theoretical model can be applied to a wide range of real-world banking systems.

In this paper we employ a simulation technique which illustrates the propagation of individual banks' default risk through the total banking market. The set-up of our theoretical model can be applied to a wide range of real-world banking systems as it allows for a convenient variation of the number of banks included, their relative market shares, capital ratios and the relation of risk weighted assets to other assets. Based on empirical rating transition probabilities, we utilise the model to measure the likelihood of individual defaults and to predict their consequences for the overall banking sector. We identify higher Tier 1 ratios as a major remedy against contagious effects.