Loss Sequencing in Banking Networks: Threatened Banks As Strategic Dominoes
57 Pages Posted: 26 Aug 2016 Last revised: 8 May 2018
Date Written: May 06, 2018
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: Suggested Citation