Financial crisis illustration showing a downward trend in investments.

The financial world improves its stability when economists devise models the reduce risk. Photo: © Rawpixel | Shutterstock.

After Lehman Brothers went bankrupt in 2008, economists have struggled to develop a way to predict future crises. Now, thanks to Dr. Kobayashi Teruyoshi of Kobe University, and Dr. Charles Brummitt of Columbia University, a new model for predicting financial crises might be available.

The problem, as Teruyoshi and Brummitt saw it, was that most models didn’t take into consideration the complicated, interwoven nature of finance and financial industry practices. At the core are two principal types of bonds that creditors can hold with an institution. Based on priority of repayment, those are senior and junior bonds.

Basically, if a company goes bankrupt, they have to pay back the senior bonds first and, if there is money left over, they repay the junior bonds. The difference between the two has generally been unclear in risk assessment in the financial world until now.

As financial institutions hold both kinds of bonds, figuring out how they might come into play in a given situation can be complex. The new model tries to allow for this, by basing predictions on multiple levels of bonds within the economy. Now, they’re able to figure out what debt structures will cause a crisis across the market, and verified them with simulations.

In addition, they figured out that, in order to prevent a financial crisis, the market should consist of at least 50% senior bonds. This way, it seems, more debts get paid than don’t, and fewer creditors lose their money.

The Basel Committee, which is based in the Bank for International Settlements and determines broad financial regulations, should find this information quite useful. The researchers believe that their study can help develop new regulations, both internationally and in various countries, which could help to prevent future financial crises. That is, as long as the current financial models remain in use.