Title: Consistency of bank defaults in financial networks with continuous credit default swaps
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.