The simulation method
The best way to understand the role of a bank from a systemic point of view is to simulate the effects of its default. We can get this way the most precise results on a bank's systemic importance. Usually, the main problem with these methods is its data need. The main characteristics of individual institutions (for example, capital buffers or size) are not enough for this kind of exercise. We also have to precisely know its exposures to other banks through financial markets since the most important contagious channels are financial markets.
In this section, we will show a simple method to identify systemic importance of a financial institution. To make it as simple as possible, we have to make some assumptions:
- We will investigate the effect of idiosyncratic defaults. After the default, all the contagious effects go through the network abruptly.
- Since all the effects go through abruptly, there won't be any adjustment procedure by banks.
- LGD is constant for all...
