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On Modelling Endogenous Default

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  • Dimitrios P. Tsomocos
  • Lea Zicchino

Abstract

Not only in the classic Arrow-Debreu model, but also in many mainstream macro models, an implicit assumption is that all agents honour their obligations, and thus there is no possibility of default. That leads to well-known problems in providing an essential role for either money or for financial intermediaries. So, in more realistic models, the introduction f minimal financial institutions, for example default and anks, becomes a logical necessity. But if default involved no penalties, everyone would do so. Hence there must be default penalties to allow for an equilibrium with partial default. What we show here is that there is an equivalence between a general equilibrium model with incomplete markets (GEI) and endogeneous default, and a model with exogenous probabilities of default (PD). The practical, policy implications are that a key function of regulators (via bankruptcy codes and default legislation), or the markets (through default premia) are broadly substitutable. The balance between these alternatives depends, however, on many institutional details, which are not modelled here, but should be a subject for future research.

Suggested Citation

  • Dimitrios P. Tsomocos & Lea Zicchino, 2005. "On Modelling Endogenous Default," OFRC Working Papers Series 2005fe15, Oxford Financial Research Centre.
  • Handle: RePEc:sbs:wpsefe:2005fe15
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    References listed on IDEAS

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    1. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
    2. Oliver Hart & John Moore, 1994. "A Theory of Debt Based on the Inalienability of Human Capital," The Quarterly Journal of Economics, Oxford University Press, vol. 109(4), pages 841-879.
    3. Pradeep Dubey & John Geanakoplos & Martin Shubik, 2005. "Default and Punishment in General Equilibrium," Econometrica, Econometric Society, vol. 73(1), pages 1-37, January.
    4. Aloisio Araujo & Mário Rui Páscoa & Juan Pablo Torres-Martínez, 2002. "Collateral Avoids Ponzi Schemes in Incomplete Markets," Econometrica, Econometric Society, vol. 70(4), pages 1613-1638, July.
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    Cited by:

    1. Gunnar Bårdsen & Kjersti-Gro Lindquist & Dimitrios P. Tsomocos, 2012. "Evaluation of Macroeconomic Models for Financial Stability Analysis," Chapters, in: The Challenge of Financial Stability, chapter 3, pages 32-58, Edward Elgar Publishing.
    2. Oriol Aspachs & Charles Goodhart & Dimitrios Tsomocos & Lea Zicchino, 2007. "Towards a measure of financial fragility," Annals of Finance, Springer, vol. 3(1), pages 37-74, January.
    3. Jong Lee & Jaemin Ryu & Dimitrios Tsomocos, 2013. "Measures of systemic risk and financial fragility in Korea," Annals of Finance, Springer, vol. 9(4), pages 757-786, November.
    4. Charles A.E. Goodhart & Pojanart Sunirand & Dimitrios P. Tsomocos, 2005. "A risk assessment model for banks," Annals of Finance, Springer, vol. 1(2), pages 197-224, September.
    5. Tsvetomira Tsenova, 2014. "International monetary transmission with bank heterogeneity and default risk," Annals of Finance, Springer, vol. 10(2), pages 217-241, May.
    6. Charles Goodhart & Pojanart Sunirand & Dimitrios Tsomocos, 2006. "A Time Series Analysis of Financial Fragility in the UK Banking System," Annals of Finance, Springer, vol. 2(1), pages 1-21, January.
    7. Conrad F. J. Beyers & Allan Freitas & Kojo A. Essel-Mensah & Reyno Seymore & Dimitrios P. Tsomocos, 2020. "A computable general equilibrium model for banking sector risk assessment in South Africa," Annals of Finance, Springer, vol. 16(2), pages 195-218, June.
    8. Frederik J.C. Beyers & Allan De Freitas & Kojo A. Essel‐Mensah & Reyno Seymore & Dimitrios P. Tsomocos, 2022. "A computable general equilibrium model as a banking sector regulatory tool in South Africa," South African Journal of Economics, Economic Society of South Africa, vol. 90(1), pages 93-120, March.

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    More about this item

    JEL classification:

    • F3 - International Economics - - International Finance
    • G3 - Financial Economics - - Corporate Finance and Governance
    • J1 - Labor and Demographic Economics - - Demographic Economics

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