Research

Publications


Working Papers

Marginal Contagion: A new approach to systemic credit risk

Abstract: This is the first model linking the theories of network and the workhorse model of default risk, Merton model. By extending Merton model to incorporate network externality, we design a new simulation model of systemic credit risk. Current workhorse models of financial contagions are prone to assume a bank’s default and test if the default could trigger further defaults of counterparties. But contagions in this model can be triggered by any small shocks and propagates through solvent banks (as the result of the contagion process, one or more banks might go bankrupt but not necessarily). A novel part of the model is deriving a closed-form solution of approximated simulation outcomes, which provides a ‘network metric’ for systemic credit risk with micro-foundation for the first time. This paper also distinguishes interconnections through debts and through equity, and finds out that higher capital ratio by issuing outside equity can raise systemic risk, which is consistent to some recent empirical findings.

Forbearance and Broken Credit Cycles

Abstract: This paper studies a microeconomic theory model on the macroeconomic impacts of banks’ strategic behaviors after financial crisis. The model shows that banks would choose leaving non-performing borrowers (forbearance, or zombie lending) to avoid recognizing loan losses which could lower banks’ capital below regulatory thresholds. This raises collateral price higher than it should be, but banks expect the decline of future collateral value when they unwind the forbearance. The expectation raises the haircut of collateral and tightens borrowing firms’ credit constraints, leading to the decline of investment and productivity.