Contagion and systemic risk in the European banking sector: implications for sustainable regulation and financial system resilience

Abstract Ensuring the long-term viability and resilience of the financial sector is a core objective of sustainable banking, particularly amid an evolving regulatory landscape and rising exposure to exogenous shocks. In Europe, commercial banks serve as the primary source of financing for households and businesses, making their stability essential to broader economic sustainability. In recent years, several systemic events, most notably the COVID-19 pandemic and the war in Ukraine, have significantly impacted the risk profile and profitability pressures faced by banks. These shocks have increased interconnectedness and prompted the development of regulatory and policy responses to maintain stability. Therefore, this study examines how external shocks affect systemic risk in the European banking sector. Using daily closing stock prices for Globally Systemically Important Banks (G-SIIs) from November 2015 to December 2024, we construct a systemic risk indicator. We apply transfer entropy (TE) method to calculate the correlation network matrix of interbank risk contagion effects, thereby assessing systemic risk. The analysis of the average risk indicator over time revealed two breakpoints: the COVID-19 pandemic and the war in Ukraine, both of which significantly increased systemic risk. Furthermore, the TE matrix highlights a highly asymmetric and heterogeneous structure of interbank risk dependencies, indicating that banks contribute to or receive risk in varying measures. These findings offer crucial insights for enhancing the regulatory framework for sustainable banking by advocating granular, network-informed macroprudential policies. Such policies, including targeted capital or liquidity requirements based on a bank’s specific network position, can enhance the responsiveness and robustness of the regulatory framework. By integrating these insights, regulators can better align financial stability objectives with the principles of sustainable banking, particularly to address emerging ESG-related risks and enhance system-wide resilience to future shocks.