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Modelling Contagion Risk Across Financial Networks
The Bank of England’s Gal-Kapadia Model Using Simudyne's SDK

The Gai-Kapadia model is a model of contagion risk in financial networks, developed by the Bank of England in the following publication: Working Paper No. 383 Contagion in Financial Networks.

The video above explores how the probability and the size of contagion in a financial system is influenced by the network’s connectivity— the interconnection between institutions. The model characterises the financial system as a complex network of institutions (agents) who interact with one another via joint financial exposures which also form links in the network.

Agents are characterised by their assets and liabilities although they remain financially solvent as long as their assets are larger than their liabilities. One agent’s liabilities are another agent’s assets. If an agent defaults when its liabilities become larger than its assets, this will induce losses to agents connected to it, thus passing on the risk of contagious default.

Depending on agent connectivity as well as their financial strength, an initial idiosyncratic default can cause a cascade of further defaults. Interestingly, this model shows that there is a complex relationship between network connectivity. It is based on the average number of banks connected to one another, their joint financial exposure and the probability and the size of default.

For instance, greater connectivity generally reduces the risk of contagion because the impact of each default leads to low impact on each of the other institutions. However, as contagion occurs, larger portions of the network are affected.

Thus, the model suggests, financial systems exhibit a robust yet fragile tendency: while the probability of contagion may be low, the effects can be extremely widespread and rapid when problems occur.

Dr Max Rollwage