Systemic Risk Management in Financial Networks with Credit Default Swaps

TL;DR

This paper explores how a regulated CDS market can be designed to rewire interbank networks, reducing systemic risk and increasing resilience to insolvency cascades through targeted surcharges based on network topology.

Contribution

It introduces a systemic insurance surcharge mechanism for CDS that incentivizes risk-reducing contracts, enhancing interbank network stability.

Findings

Regulated CDS market reduces insolvency cascades.

Targeted surcharges effectively penalize systemic risk contributors.

Simulation shows increased resilience in the interbank system.

Abstract

We study insolvency cascades in an interbank system when banks are allowed to insure their loans with credit default swaps (CDS) sold by other banks. We show that, by properly shifting financial exposures from one institution to another, a CDS market can be designed to rewire the network of interbank exposures in a way that makes it more resilient to insolvency cascades. A regulator can use information about the topology of the interbank network to devise a systemic insurance surcharge that is added to the CDS spread. CDS contracts are thus effectively penalized according to how much they contribute to increasing systemic risk. CDS contracts that decrease systemic risk remain untaxed. We simulate this regulated CDS market using an agent-based model (CRISIS macro-financial model) and we demonstrate that it leads to an interbank system that is more resilient to insolvency cascades.