Counterparty and Systemic Risk: Exposure Networks

Kimmo Soramäki and Samantha Cook

Financial institutions are interconnected partly because they engage in series of bilateral transactions, which occur as institutions seek to transfer risk. One bank might have excessive residual exposure to interest rate movements, for example, while another might wish to earn premiums by increasing its exposure: these banks meet in a virtual market and exchange “fixed” and “floating” rates. As another example, two banks might have, respectively, surplus and deficit liquidity; these banks might agree on an unsecured loan, a repurchase agreement or a commitment line (Langfield and Soramäki, 2014). The possibilities for relationships of this type are myriad. Transactions of this type lead to counterparty risk: by engaging in such transactions, financial institutions transfer successfully the underlying risk, and as a by-product often gain a stake in the fortunes of their counterparty. This exposure thus forms a link between the two institutions. Moreover, the fortunes of banks are usually highly correlated with one another due to exposures to common risk factors. Retail banks, for example, have similar exposures to credit and interest rate risk: the archetypal common exposure is a