IMF Working Papers

Sandcastles and Financial Systems: A Sandpile Metaphor

By Francesco Luna, Luisa Zanforlin

February 14, 2025

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Format: Chicago

Francesco Luna, and Luisa Zanforlin. "Sandcastles and Financial Systems: A Sandpile Metaphor", IMF Working Papers 2025, 041 (2025), accessed February 23, 2025, https://doi.org/10.5089/9798229002240.001

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Disclaimer: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

Summary

Social welfare costs from bank resolution, including contagion and moral hazard, are often thought to be minimized when supervisors can direct the merger of a failing bank with a sound, healthy one. However, social losses may become even larger if the absorbing institutions fail themselves. We ask whether social welfare losses are indeed lower when supervisors intervene rather than not. We use the sand pile/Abelian model as a metaphor to model financial losses which, as sand grains that fall onto a pile, eventually lead to a slide/failure. When capital in the system is insufficient to absorb the failing institution there will be welfare losses. Results suggest that, over the longer-term, social costs are lower when supervisors manage mergers. Additionally, financial networks that have a structure that minimizes social losses also minimize crises frequency. However, the bank employed resolution strategy will determine which financial network structures are associated with the minimum average loss per bankruptcy event.

Subject: Bank resolution, Distressed institutions, Financial crises, Financial institutions

Keywords: Applied Abelian model, Bank Regulation and Supervision, Bank resolution, Bank Resolution, Banking, Banking Crisis, Bankrupcy, Distressed institutions, Financial Economics, Financial Networks, Selforganized Criticality

Publication Details

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