Debt Priority Structure And The Systemic Risk Of A Financial Crisis

A technical analysis of how networks of debt obligations with different priorities can lead to systemic risk which can precipitate a financial crisis can be summed up with one simple conclusion:

a necessary condition for minimizing systemic risk is that at least 50% of debts in the entire market should exist as senior debts.

Previous attempts to reduce systemic risk in the banking sector, such as those imposed by the FDIC have focused on a similarly simple indicator - limits on the amount of leverage that an institution may have relative to its equity (typically banks must have equity reserves of at least 20% of their total assets).

This study says that just as there is a minimum level of equity investment that matters, there is also a minimum senior to junior debt ratio that matters.  Thus, a bank with 20% equity, 40% senior debt, and 40% junior debt, or another less risky mix of assets, faces minimal systemic risk, while the presence of banks with more risky portfolios than this benchmark significantly enhances the systemic risk that the banking system will collapse in a financial crisis.