Synopsis: Debts and Financial Crises

A model of a banking network predicts the balance of high- and low-priority debts that ensures financial stability.

When an institution goes bankrupt, it sells its remaining assets to pay off debts. So-called “senior” debts have a higher priority than junior ones and are repaid first. According to a new model, the distribution of senior vs junior debts held by banks within a financial network may affect the risk that a systemic crisis occurs. Charles Brummitt at the Center for the Management of Systemic Risk of Columbia University and Teruyoshi Kobayashi at Kobe University in Japan have developed a model that connects debt seniority with the risk of large-scale crises in a network of financial institutions.

The authors describe a system of banks indebted to one another. The banks form a “multiplex network,” akin to a social network in which the same individuals can be linked by different relationships (friend, family, colleague). The authors assume different distributions of debt seniorities and, for each, compute the probability that a cascade of bankruptcies is triggered by a small number of initial bankruptcies. The results suggest that the balance of senior and junior debts is an important factor in a system’s vulnerability to default. In particular, networks in which banks hold 50% to 100% more senior debts than junior debts minimize the risk of a global crisis. The results might encourage financial regulators to explore a “debt-seniority-mixing” requirement as a means of stabilizing the economy.

This research is published in Physical Review E.

–Matteo Rini


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