Modeling Economic Meltdown: Learning from the (very recent) Past

"Just a little off the top, please!"

In a new paper to be published by The Journal of Monetary Economics, authors Prasanna Gai, Andrew Haldaney and Sujit Kapadiaz identify "haircuts" as the main culprit in the 2008/2009 banking meltdown.

This paper develops a network model of interbank lending in which unsecured claims, repo activity and shocks to the haircuts applied to collateral assume centre stage. We show how systemic liquidity crises of the kind associated with the interbank market collapse of 2007-8 can arise within such a framework, with funding contagion spreading widely through the web of interlinkages. Our model illustrates how greater complexity and concentration in the Financial network may amplify this fragility. The analysis suggests how a range of policy measures - including tougher liquidity regulation, macro-prudential policy, and surcharges for systemically important financial institutions - could make the financial system more resilient.