Strategic default in financial networks

Professor Nizar Allouch

by Nizar Allouch, University of Kent and Maya Jalloul, Queen Mary, University of London. Discussion paper KDPE 1721, December 2017.

Non-technical summary:

Financial institutions carry out various transactions with each other, including risk-sharing and insurance. The architecture of the network of transactions between institutions can support financial stability because it enables them to share funding or transfer risk. But these linkages can also facilitate the diffusion of shocks through the system, due to chains of default and the domino effect. This is referred to as systemic risk. Systemic risk is costly for individuals, institutions and economies, as demonstrated by the last financial crisis (of 2008). The obvious need for a stable financial system has led to a significant interest in policies that could reduce systemic risk and mitigate contagion.

This paper investigates a model of strategic interactions in financial networks, where the decision by one agent on whether or not to default impacts the incentives of other agents to escape default. Agents’ payoffs are determined by the clearing mechanism introduced in the seminal contribution of Eisenberg and Noe (2001). We first show the existence of a Nash equilibrium of this default game. Next, we develop an algorithm to find all Nash equilibria that relies on the financial network structure. From a policy perspective, given that inefficient coordination on a bad Nash equilibrium might pose a severe economic problem, there is a need for financial institutions fostering efficient coordination of agents’ decisions. Recently, central clearing has become the cornerstone of policy reform in financial markets since it limits the scope of default contagion. Our analysis shows that introducing a central clearing counterparty (CCP) also allows agents to coordinate on the efficient equilibrium at no additional cost. As a consequence, our result reinforces the key role central clearing counterparty (CCP) plays in stabilising financial markets.

You can download the complete paper here.