How do banks' interconnections in the euro area contribute to the vulnerability of the banking system? We study both the direct interconnections (banks lend to each other) and the indirect interconnections (banks are exposed to similar sectors of the economy). These complex linkages make the banking system more vulnerable to contagion risks.

We use a unique supervisory dataset of the European Central Bank with the 26 largest banks in the euro area. Introducing a new measure of indirect interconnections, we assess to what extent banks are significantly exposed to devaluation risk of commonly held assets.

We find that for small shocks, banks that operate in multiple countries make the banking system more resilient. But for large shocks, international diversification makes the banking system less resilient. While contagion risk is usually ignored in supervisory stress tests, it can have significant impacts on banks' solvency and should influence how supervisors design regulations. However, we find there is no one-size-fits-all solution: the optimal financial architecture depends on the shocks considered and the international diversification.