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How to manage a bank default

How should financial authorities contain the risk of bank defaults? Two Swiss academics have sketched an answer.

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What is the best way to manage bank defaults?

This is a crucial question. Banks do not just have a critical monetary function in modern economies, they also have an important symbolic function: when your money is at risk, nothing feels safe.

A pair of Swiss academics have attempted to answer the question. ETH Zurich’s Roger Wattenhofer and Pal Andras Papp released a paper on November 23 examining a simplified banking model that does better than others by allowing banks to both make and lose money from the defaults of their rivals.

Most students of economics are used to equilibrium models of markets. To give a simple example, when there is a spike in demand – perhaps the result of a new regulation that gives foreign investors access to a market – budding economists will draw a new demand curve and analyse the latest equilibirum point where demand and supply meet. This is a useful way to compare two market states before and after some event. It is no good at helping us understand the transition from one to the other.

Wattenhofer and Papp opted for a sequential model, giving them the power to talk about how markets adjust from one equilibrium point to another.

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