Illiquidity and Insolvency: a Double Cascade Model of Financial Crises
AbstractIn the aftermath of the interbank market collapse of 2007-08, the traditional idea that systemic risk is primarily the risk of cascading bank defaults has evolved into the view that it involves both cascading bank defaults as well as funding liquidity shocks, and that both types of shocks impair the functioning of the remaining undefaulted banks. In current models of systemic risk, these two facets, namely funding illiquidity and insolvency, are treated as two separate phenomena. Our paper introduces a deliberately simplified model which integrates insolvency and illiquidity in financial networks and that can provide answers to the question of how illiquidity or default of one bank can influence the overall level of liquidity stress and default in the network. First, this paper proposes a stylized model of individual bank balance sheets that builds in regulatory constraints. Secondly, three different possible states of a bank, namely the normal state, the stressed state and the insolvent state, are identified with conditions on the bank's balance sheet. Thirdly, the paper models the behavioural response of a bank when it finds itself in the stressed or insolvent states. Importantly, a stressed bank seeks to protect itself from the default of its counterparties, but creates stress in the network by forcing its debtor banks to raise cash. Versions of these proposed models can be solved by large-network asymptotic cascade formulas. Details of numerical experiments are given that verify that these asymptotic formulas yield the expected quantitative agreement with Monte Carlo results for large finite networks. 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.
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Bibliographic InfoPaper provided by arXiv.org in its series Papers with number 1310.6873.
Date of creation: Oct 2013
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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)
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