Tuesday, February 26th @ 11:00-12:30 PM (1011 Evans Hall)
Samim Ghamami, Goldman Sachs and UC Berkeley Center for Risk Management Research
We study the spread of losses and defaults through financial networks focusing on two important elements of regulatory reforms: collateral requirements and bankruptcy stay rules in over-the-counter (OTC) markets. Under "segregated" collateral requirements, one firm can benefit from the failure of another, the failure frees the committed collateral of the surviving firm giving it additional resources to make other payments. In OTC derivatives markets, similarly, one firm may obtain additional resources upon the failure of another if it terminates its in the money derivatives with the failed entity. Studying contagion in the presence of this real world phenomenon becomes challenging. Our proposed model deviates from the existing network models to capture collateral and accelerated contract termination payments. The model also incorporates fire sales externalities when collateral is held in illiquid assets. We show that asset fire sales increase the risk of contagion if illiquid collateral is seized and sold immediately upon defaults. We also analyze the impact of different bankruptcy stay rules on contagion. Some of our results contrast with the post-crisis stay rules. For instance, we show that when banks are not highly leveraged in terms of their OTC derivatives transactions, which is now the case due to the impact of regulatory reforms, symmetric contract termination in the absence of automatic stays can reduce the risk of contagion.