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

50 Pages Posted: 12 Feb 2021

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 between organizations in financial networks can lead to multiple possible equilibrium outcomes. A multiplicity arises if and only if there exists a certain type of dependency cycle in the network that allows for self-fulfilling chains of defaults. We provide necessary and sufficient conditions for banks' solvency in any equilibrium. Building on these conditions, we characterize the minimum bailout payments needed to ensure systemic solvency, as well as how solvency can be ensured by guaranteeing a specific set of debt payments. Bailout injections needed to eliminate self-fulfilling cycles of defaults (credit freezes) are fully recoverable, while those needed to prevent cascading defaults outside of cycles are not. We show that the minimum bailout problem is computationally hard, but provide an upper bound on optimal payments and show that the problem has intuitive solutions in specific network structures such as those with disjoint cycles or a core-periphery structure.

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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