Dynamic Spatial Treatment Effects and Network Fragility: Theory and Evidence from European Banking

Kikuchi, Tatsuru (2025): Dynamic Spatial Treatment Effects and Network Fragility: Theory and Evidence from European Banking.

Abstract

This paper develops and empirically implements a continuous functional framework for analyzing systemic risk in financial networks, building on the dynamic spatial treatment effect methodology established in \citet{kikuchi2024dynamical}. We extend the Navier-Stokes-based approach from \citet{kikuchi2024navier} to characterize contagion dynamics in the European banking system through the spectral properties of network evolution operators. Using high-quality bilateral exposure data from the European Banking Authority Transparency Exercise (2014-2023), we estimate the causal impact of the COVID-19 pandemic on network fragility using spatial difference-in-differences methods adapted from \citet{kikuchi2024dynamical}. Our empirical analysis reveals that COVID-19 elevated network fragility, measured by the algebraic connectivity $\lambda_2$ of the system Laplacian, by 26.9\% above pre-pandemic levels (95\% CI: [7.4\%, 46.5\%], p$<$0.05), with effects persisting through 2023. Paradoxically, this occurred despite a 46\% reduction in the number of banks, demonstrating that consolidation increased systemic vulnerability by intensifying interconnectedness—consistent with theoretical predictions from continuous spatial dynamics. Our findings validate the key predictions from \citet{kikuchi2024dynamical}: treatment effects amplify over time through spatial spillovers, consolidation increases fragility when coupling strength rises, and systems exhibit structural hysteresis preventing automatic reversion to pre-shock equilibria. The results demonstrate the empirical relevance of continuous functional methods for financial stability analysis and provide new insights for macroprudential policy design. We propose network-based capital requirements targeting spectral centrality and stress testing frameworks incorporating diffusion dynamics to address the coupling externalities identified in our analysis.

• Item Type: MPRA Paper
• Language: English
• Keywords: inancial networks, Systemic risk, Navier-Stokes dynamics, Spatial treatment effects, Network contagion, Banking regulation, COVID-19
• Subjects: C - Mathematical and Quantitative Methods > C3 - Multiple or Simultaneous Equation Models ; Multiple Variables > C31 - Cross-Sectional Models ; Spatial Models ; Treatment Effect Models ; Quantile Regressions ; Social Interaction Models; C - Mathematical and Quantitative Methods > C6 - Mathematical Methods ; Programming Models ; Mathematical and Simulation Modeling > C63 - Computational Techniques ; Simulation Modeling; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E44 - Financial Markets and the Macroeconomy; G - Financial Economics > G0 - General > G01 - Financial Crises; G - Financial Economics > G2 - Financial Institutions and Services > G21 - Banks ; Depository Institutions ; Micro Finance Institutions ; Mortgages; G - Financial Economics > G2 - Financial Institutions and Services > G28 - Government Policy and Regulation

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