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

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  • Matthew O Jackson
  • Agathe Pernoud

Abstract

We analyze how interdependencies in financial networks can lead to self-fulfilling insolvencies and multiple possible equilibrium outcomes. Multiplicity arises if a certain type of dependency cycle exists in the network. We show that finding the cheapest bailout policy that prevents self-fulfilling insolvencies is computationally hard, but that the optimal policy has intuitive features in some typical network structures. Leveraging indirect benefits ensures systemic solvency at a cost that never exceeds half of the overall shortfall. In core-periphery networks, it is optimal to bail out peripheral banks first as opposed to core banks.

Suggested Citation

  • Matthew O Jackson & Agathe Pernoud, 2024. "Credit Freezes, Equilibrium Multiplicity, and Optimal Bailouts in Financial Networks," The Review of Financial Studies, Society for Financial Studies, vol. 37(7), pages 2017-2062.
    • Handle: RePEc:oup:rfinst:v:37:y:2024:i:7:p:2017-2062.
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    File URL: http://hdl.handle.net/10.1093/rfs/hhad096
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    Cited by:

    1. Péter Csóka & P. Jean-Jacques Herings, 2021. "Uniqueness of Clearing Payment Matrices in Financial Networks," CERS-IE WORKING PAPERS 2134, Institute of Economics, Centre for Economic and Regional Studies.
    2. Péter Csóka & P. Jean-Jacques Herings, 2022. "Centralized Clearing Mechanisms in Financial Networks: A Programming Approach," CERS-IE WORKING PAPERS 2208, Institute of Economics, Centre for Economic and Regional Studies.
    3. Chien-Hsiang Yeh, 2022. "Uniqueness of Equilibria in Interactive Networks," Papers 2206.00158, arXiv.org.
    4. Hamed Amini & Zhongyuan Cao & Agnes Sulem, 2021. "Limit Theorems for Default Contagion and Systemic Risk," Papers 2104.00248, arXiv.org.

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    More about this item

    Keywords

    D85; G11; G32; G33; G38;
    All these keywords.

    JEL classification:

    • D85 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Network Formation
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
    • G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation

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