Interbank contagion and resolution procedures: inspecting the mechanism

Edoardo Gaffeo and Massimo Molinari

No 2013/09, DEM Discussion Papers from Department of Economics and Management

Abstract: This paper develops a network model of a stylized banking system in which banks are connected to one another through interbank claims, which allows us to study the diffusion of default avalanches triggered by an exogenous shock under a number of different assumptions on the degree of interconnectedness, level of capitalization, liquidity buffers, the size of the interbank market and fire-sales. We expand upon the existing literature by embedding two alternative resolution mechanisms. First, liquidations triggered by either illiquidity or insolvency-related distress implying asset sales and compensation of creditors. Second, a bail-in mechanism avoiding bank closure by forcing a recapitalization provided by bank creditors. Our model speaks to how contagion dynamics unravel via illiquidity-driven defaults in the first case and higher-order losses in the latter one. Within this framework, we show how counter-party liquidity risk externality can be resolved and put forward a macro-criterion to assess the adequacy of the liquidity ratio introduced with Basel III.

Keywords: Systemic Risk; Banking Network; Resolution Procedures (search for similar items in EconPapers)
JEL-codes: D85 G28 G33 (search for similar items in EconPapers)
Date: 2013
New Economics Papers: this item is included in nep-ban, nep-cba, nep-net and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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Journal Article: Interbank contagion and resolution procedures: inspecting the mechanism (2015)
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