Systemic Risk and Community Structure in the European Banking System

Financial contagion and systemic risk have become increasingly relevant after the financial crisis in 2008. Network theory is a powerful framework for the analysis of these phenomena and is becoming a standard tool in the literature. This paper investigates the properties of the European banking system, focusing on the community structure of the network to identify the potential channels for the propagation of financial distress. The network structure is estimated from the sparse partial correlation of CDS spreads using tlasso, a robust technique that induces sparsity in the network. The optimal community structure is then estimated by a procedure that maximises modularity. The analysis shows that, despite the high level of internationalization of the financial system, it exist a clear community structure that mirrors the geographical location of the banks. Finally, a decomposition of strength centrality based on the estimated community structure is provided. Such decomposition represents a useful and easy-to-implement tool to monitor the exposure to financial contagion, integrating the traditional risk management tools.