Sandcastles and Financial Systems: A Sandpile Metaphor

IMF Working Papers, February 14, 2025

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Investigates whether social welfare losses are lower when supervisors intervene (directing merger of a failing bank with a sound one) versus when they do not.
Uses the sand pile/Abelian model as a metaphor to model financial losses: losses accumulate like sand grains falling onto a pile and eventually lead to a slide/failure.
Focuses on how insufficient capital in the system to absorb a failing institution creates welfare losses.

Over the longer-term, social costs are lower when supervisors manage mergers.
Financial networks that have a structure that minimizes social losses also minimize crises frequency.
The bank resolution strategy employed determines which financial network structures are associated with the minimum average loss per bankruptcy event.
When absorbing institutions fail themselves, social losses may become even larger, challenging the view that directed mergers always minimize social welfare costs.
Social welfare costs considered include contagion and moral hazard associated with bank resolution.

Supervisor-managed mergers can reduce long-term social costs, but the effectiveness depends on network structure and capital adequacy.
Design of resolution strategies should account for how different financial network structures interact with those strategies to affect average loss per bankruptcy event.
Strengthening capital buffers across the system is implied as necessary to reduce instances where the system cannot absorb failing institutions, thereby lowering welfare losses.

Subject: Bank resolution, Commercial banks, Crisis resolution, Distressed institutions, Financial crises, Financial institutions
Keywords: Applied Abelian model, Bank Regulation and Supervision, Bank Resolution, bank resolution regime supervisor, Banking, Banking Crisis, Bankrupcy, banks fail, Commercial banks, Crisis resolution, Distressed institutions, Financial Economics, Financial Networks, Global, loss distribution, resolution strategy, Selforganized Criticality, shareholder bank, welfare loss