Orderly Resolutions in a System of Financially Linked Firms

Abstract

This paper investigates orderly resolutions of debts in a system of firms holding debts both within and outside the system. A firm defaulting on its external debts, say a bank defaulting on customers' deposits, becomes bankrupt. An orderly resolution avoids coordination failures and uncontrolled contagion of defaults: it assigns the amount each firm receives and reimburses both inside and outside the system, while respecting debt priorities and stockholders' limited liability and requiring no external bail-out. I present properties that determine which firms are left bankrupt and how much the non-bankrupt ones reimburse and receive. The main properties rely on the priority of external creditors at the system level and the proportionality principle.

Keywords: cross-liabilities, defaults, bankruptcy, resolution, proportionality, entropy

JEL Classification: D71, D85, G33, G38