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Defaulting firms and systemic risks in financial networks: a normative approach

Author

Listed:
  • Nicolas Houy

    (University of Lyon
    GATE Lyon Saint-Étienne)

  • Frédéric Jouneau

    (University of Lyon
    GATE Lyon Saint-Étienne
    Université Lyon 2)

  • François Le Grand

    (Emlyon Business School
    ETH Zurich)

Abstract

We study systemic risk in an interbank market, employing an explicit axiomatization inspired by Eisenberg and Noe (Manag Sci 47(2):236–249, 2001) and Rogers and Veraart (Manag Sci 59(4):882–898, 2013). Instead of focusing on a clearing payment scheme, we characterize the smallest (in the sense of inclusion) set of ex post defaulting firms. This novel approach allows us to analyze the normative implications of the Eisenberg–Noe axioms. We first show that the Absolute Priority axiom, which states that defaulting firms must end up with zero net worth, has no impact on minimal default sets. Second, relaxing the Limited Payments axiom, which can be interpreted as allowing a central planner to transfer resources from rich firms to poor, does not further reduce the minimal default sets, although other default sets are possible. Our normative analysis sheds new light on the possible impacts of clearing mechanisms on default outcomes.

Suggested Citation

  • Nicolas Houy & Frédéric Jouneau & François Le Grand, 2020. "Defaulting firms and systemic risks in financial networks: a normative approach," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 70(2), pages 503-526, September.
    • Handle: RePEc:spr:joecth:v:70:y:2020:i:2:d:10.1007_s00199-019-01217-4
    DOI: 10.1007/s00199-019-01217-4
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    More about this item

    Keywords

    Credit risk; Systemic risk; Clearing system; Financial system;
    All these keywords.

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • 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

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