Loss Sequencing in Banking Networks: Threatened Banks As Strategic Dominoes

57 Pages Posted: 26 Aug 2016 Last revised: 8 May 2018

See all articles by Ngoc-Khanh Tran

Ngoc-Khanh Tran

Finance Dept., Pamplin College of Business, Virginia Tech; Olin Business School- Washington University in St. Louis

Thao Vuong

Washington University in St. Louis - John M. Olin Business School

Richard J. Zeckhauser

Harvard University - Harvard Kennedy School (HKS); National Bureau of Economic Research (NBER)

Date Written: May 06, 2018

Abstract

A single large loss may impact our networked financial system significantly differently than would a same cumulative magnitude sequence of moderate losses. Banks can choose whether to bail out their creditors after each loss in a sequence, or to walk away. Banks make bailout decisions strategically, based on their self-interested assessment of losses, so walkaways are more attractive following large losses. Early decisions by one bank affect subsequent decisions and eventual losses to others. Hence loss sequencing matters. Government policy can force threatened banks to liquidate or sell themselves, or can choose to overlook their short-term problems and bail them out with term limits. The former policy concentrates moderate losses into a single large event; the latter prevents a massive single loss, but promotes multiple subsequent smaller losses. Either policy could prove optimal depending on identifiable circumstances. These findings have important implications for on-going policy debates that emanated from the 2008 meltdown.

Keywords: Banking Network, Cascades, Bailouts, Liquidations, Loss Sequence

JEL Classification: G21, G01, G28, G33

Suggested Citation

Tran, Ngoc-Khanh and Vuong, Thao and Zeckhauser, Richard J., Loss Sequencing in Banking Networks: Threatened Banks As Strategic Dominoes (May 06, 2018). HKS Working Paper No. 16-030; Finance Down Under 2017 Building on the Best from the Cellars of Finance. Available at SSRN: https://ssrn.com/abstract=2829691 or http://dx.doi.org/10.2139/ssrn.2829691

Ngoc-Khanh Tran

Finance Dept., Pamplin College of Business, Virginia Tech ( email )

1016 Pamplin Hall (0221)
Blacksburg, VA 24060-0221
United States

HOME PAGE: http://https://www.nktran.com/

Olin Business School- Washington University in St. Louis ( email )

One Brookings Dr, Campus Box 1133
St. Louis, MO 63130
United States

HOME PAGE: http://https://www.nktran.com/

Thao Vuong

Washington University in St. Louis - John M. Olin Business School ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

Richard J. Zeckhauser (Contact Author)

Harvard University - Harvard Kennedy School (HKS) ( email )

79 John F. Kennedy Street
Cambridge, MA 02138
United States
617-495-1174 (Phone)
617-384-9340 (Fax)

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States
617-495-1174 (Phone)
617-496-3783 (Fax)

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