Title: Consistency of bank defaults in financial networks with continuous credit default swaps
Abstract:
We consider financial networks consisting of both debt and credit default swap contracts. We show that these networks are prone to a new kind of systemic risk that has gone unnoticed so far in the literature: that it might not even be well-defined which banks are in default and which are not.
We prove that it is computationally infeasible (NP-hard) to even check whether an arbitrary given network has well-defined defaults or not. Despite this negative finding, we show that many networks can still be efficiently dealt with using our new dependency analysis framework.
We close with a policy recommendation: we show that banning naked CDSs would prevent the problems associated with ill-defined defaults.
