Measuring Bank Contagion in Europe Using Binary Spatial Regression Models

The recent European sovereign debt crisis clearly illustrates the importance of measuring the contagion effects of bank failures. Indeed, to better understand and monitor contagion risk, the European Central Bank is assuming the supervision of the largest banks in each of the member states. We propose a measure of contagion risk based on the spatial autocorrelation parameter of a binary spatial autoregressive model. Using different specifications of the interbank connectivity matrix and of the determinants of bank failures, we estimate the contagion parameter for banks within the Eurozone, between 1996 and 2012. We provide evidence of high levels of systemic risk due to contagion.