Illiquidity and Insolvency: a Double Cascade Model of Financial Crises
AbstractIn the aftermath of the interbank market collapse of 2007-08, the scope of systemic risk research has broadened to encompass a wide range of channels, notably asset correlations, default contagion, illiquidity contagion, and asset firesales. In current models of systemic risk, two facets of contagion, namely funding illiquidity and insolvency, are treated as two distinct and separate phenomena. The main goal of the double cascade model we introduce is to integrate these two facets. In a default cascade, insolvency of a given bank will create a shock to the asset side of the balance sheet of each of its creditor banks. Under some circumstances, such "downstream" shocks can cause further insolvencies that may build up to create a global insolvency cascade. On the other hand, in a stress cascade, illiquidity that hits a given bank will create a shock to the liability side of the balance sheet of each of its debtor banks. Such "upstream" shocks can cause further illiquidity stresses that may build up to create a global illiquidity cascade. Our paper introduces a deliberately simplified network model of insolvency and illiquidity that can quantify how illiquidity or default of one bank influences the overall level of liquidity stress and default in the network. Under an assumption we call "locally tree-like independence", we derive large-network asymptotic cascade formulas. Results of numerical experiments then demonstrate that these asymptotic formulas agree qualitatively with Monte Carlo results for large finite networks, and quantitatively except when the system is placed in an exceptional "knife-edge" configuration. These experiments illustrate clearly our main conclusion that in financial networks, the average default probability is inversely related to strength of banks' stress response and therefore to the overall level of stress in the network.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
Bibliographic InfoPaper provided by arXiv.org in its series Papers with number 1310.6873.
Date of creation: Oct 2013
Date of revision: Apr 2014
Contact details of provider:
Web page: http://arxiv.org/
This paper has been announced in the following NEP Reports:
- NEP-ALL-2013-11-02 (All new papers)
- NEP-BAN-2013-11-02 (Banking)
- NEP-CBA-2013-11-02 (Central Banking)
- NEP-NET-2013-11-02 (Network Economics)
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Nier, Erlend & Yang, Jing & Yorulmazer, Tanju & Alentorn, Amadeo, 2008.
"Network models and financial stability,"
Bank of England working papers
346, Bank of England.
- Gai, Prasanna & Haldane, Andrew & Kapadia, Sujit, 2011. "Complexity, concentration and contagion," Journal of Monetary Economics, Elsevier, vol. 58(5), pages 453-470.
- Thomas R. Hurd & James P. Gleeson, 2011. "A framework for analyzing contagion in banking networks," Papers 1110.4312, arXiv.org.
- Larry Eisenberg & Thomas H. Noe, 2001. "Systemic Risk in Financial Systems," Management Science, INFORMS, vol. 47(2), pages 236-249, February.
- Rodrigo Cifuentes & Hyun Song Shin & Gianluigi Ferrucci, 2005. "Liquidity Risk and Contagion," Journal of the European Economic Association, MIT Press, vol. 3(2-3), pages 556-566, 04/05.
- Adrian, Tobias & Shin, Hyun Song, 2010.
"Liquidity and leverage,"
Journal of Financial Intermediation,
Elsevier, vol. 19(3), pages 418-437, July.
- Rodrigo Cifuentes & Gianluigi Ferrucci & Hyun Song Shin, 2005. "Liquidity risk and contagion," Bank of England working papers 264, Bank of England.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (arXiv administrators).
If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.
If references are entirely missing, you can add them using this form.
If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.
If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.
Please note that corrections may take a couple of weeks to filter through the various RePEc services.