Systemic risk management in financial networks with credit default swaps

Abstract

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