Optimal bailouts and strategic debt forgiveness in financial networks

Abstract

A financial system is represented by a network, where nodes correspond to banks, and directed labeled edges correspond to debt contracts between banks. Once a payment schedule has been defined, the liquidity of the system is defined as the sum of total payments made in the network. Maximizing systemic liquidity is a natural objective of any financial authority, so, we study the setting where the financial authority offers bailout money to some bank(s) or forgives the debts of others in order to help them avoid costs related to default, and, hence, maximize liquidity. We investigate the approximation ratio provided by the greedy bailout policy compared to the optimal one, and we study the computational hardness of finding the optimal debt-removal and budget-constrained optimal bailout policy, respectively.

We also study financial systems from a game-theoretic standpoint. We observe that the removal of some incoming debt might be in the best interest of a bank, if that helps one of its borrowers remain solvent and avoid costs related to default. Assuming that a bank's well-being (i.e., utility) is aligned with the incoming payments they receive from the network, we define and analyze a game among banks who want to maximize their utility by strategically giving up some incoming payments. In addition, we extend the previous game by considering bailout payments. After formally defining the above games, we prove results about the existence and quality of pure Nash equilibria, as well as the computational complexity of finding such equilibria.