We propose and estimate a financial distress model that explicitly accounts for the interactions or spill-over effects between financial institutions, through the use of a spatial continuity matrix that is built from financial network data of interbank transactions. Such setup of the financial distress model allows for the empirical validation of the importance of network externalities in determining financial distress, in addition to institution specific and macroeconomic covariates. The relevance of such specification is that it incorporates simultaneously micro-prudential factors (Basel 2) as well as macro-prudential and systemic factors (Basel 3) as determinants of financial distress. Results indicate network externalities are an important determinant of financial health of a financial institution. The parameter that measures the effect of network externalities is both economically and statistical significant and its inclusion as a risk factor reduces the importance of the firm specific variables such as the size or degree of leverage of the financial institution. In addition, we analyze the policy implications of the network factor model for capital requirements and deposit insurance pricing.
