Credit Freezes, Equilibrium Multiplicity, and Optimal Bailouts in Financial Networks

54 Pages Posted: 12 Feb 2021 Last revised: 13 Jun 2022

See all articles by Matthew O. Jackson

Matthew O. Jackson

Stanford University - Department of Economics; Santa Fe Institute

Agathe Pernoud

Stanford University - Department of Economics

Date Written: November 22, 2020

Abstract

We analyze how interdependencies in financial networks can lead to self-fulfilling insolvencies and multiple possible equilibrium outcomes. We show that multiplicity arises if and only if there exists a certain type of dependency cycle in the network, and characterize banks' defaults in any equilibrium. We use this analysis to show that finding the cheapest bailout policy that prevents self-fulfilling insolvencies is computationally hard (and hard to approximate), but that the problem has intuitive solutions in specific network structures. Bailouts have an indirect value as making a bank solvent improves its creditors' balance sheets and reduces their bailout costs, and we show that an algorithm that leverages indirect benefits ensures systemic solvency at a cost that never exceeds half of the overall shortfall. In core-periphery networks, indirect bailouts are optimal: bailing out peripheral banks first as opposed to targeting core banks directly.

Keywords: Financial Networks, Markets, Systemic Risk, Financial Crisis, Networks, Banks, Credit Freeze, Default Risk, Financial Interdependencies

JEL Classification: D85, F15, F34, F36, F65, G15, G32, G33, G38

Suggested Citation

Jackson, Matthew O. and Pernoud, Agathe, Credit Freezes, Equilibrium Multiplicity, and Optimal Bailouts in Financial Networks (November 22, 2020). Available at SSRN: https://ssrn.com/abstract=3735251 or http://dx.doi.org/10.2139/ssrn.3735251

Matthew O. Jackson (Contact Author)

Stanford University - Department of Economics ( email )

Landau Economics Building
579 Serra Mall
Stanford, CA 94305-6072
United States
1-650-723-3544 (Phone)

HOME PAGE: http://www.stanford.edu/~jacksonm

Santa Fe Institute

1399 Hyde Park Road
Santa Fe, NM 87501
United States

Agathe Pernoud

Stanford University - Department of Economics ( email )

Landau Economics Building
579 Serra Mall
STANFORD, CA 94305-6072
United States

HOME PAGE: http://web.stanford.edu/~agathep

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