Triangle Seminars

Abstract:
The importance of adequately modeling credit risk has once again been
highlighted in the recent financial crisis. Defaults tend to cluster
around times of economic stress due to poor macro-economic conditions,
but also by directly triggering each other through contagion. Although
credit default swaps have radically altered the dynamics of contagion
for more than a decade, models quantifying their impact on systemic risk
are still missing. Here, we examine contagion through credit default
swaps in a stylized economic network of corporates and financial
institutions. We analyse such a system using a stochastic setting, which
allows us to exploit limit theorems to exactly solve the contagion
dynamics for the entire system. Our analysis shows that CDS, when used
to expand banks' loan books (arguing that CDS would offload the
additional risks from banks' balance sheets), can actually lead to
greater instability of the entire network in times of economic stress,
by creating additional contagion channels. This can lead to considerably
enhanced probabilities for the occurrence of very large losses and very
high default rates in the system. Our approach adds a new dimension to
research on credit contagion, and could feed into a rational
underpinning of an improved regulatory framework for credit derivatives.