Dynamic Clearing and Contagion in Financial Networks

TL;DR

This paper extends the Eisenberg-Noe model to include time dynamics and separate accounts, enabling a more detailed analysis of default risk, insolvency, and illiquidity in financial networks.

Contribution

It introduces a dynamic framework that distinguishes between delinquency, default, insolvency, and illiquidity, improving the modeling of financial contagion over time.

Findings

Enhanced understanding of default mechanisms in dynamic settings

Ability to differentiate between insolvency and illiquidity defaults

Framework applicable to real-time risk assessment in financial networks

Abstract

In this paper we introduce a generalized extension of the Eisenberg-Noe model of financial contagion to allow for time dynamics of the interbank liabilities, including a dynamic examination of default risk. This framework separates the cash account and long-term capital account to more accurately model the health of a financial institution. In doing so, such a system allows us to distinguish between delinquency and default as well as between defaults resulting from either insolvency or illiquidity.