On the optimal control of interbank contagion in the euro area banking system

Gábor Fukker and Christoffer Kok

Journal of Financial Stability, 2024, vol. 71, issue C

Abstract: In this paper we present a methodology of model-based calibration of additional capital needed in an interconnected financial system to minimize potential contagion losses. Building on ideas from combinatorial optimization tailored to controlling contagion in case of complete information about an interbank network, we augment the model with three plausible types of fire sale mechanisms. We then demonstrate the power of the methodology on the euro area banking system based on a network of 373 banks. On the basis of an exogenous shock leading to defaults of some banks in the network, we find that the contagion losses and the policy authority’s ability to control them depend on the assumed fire sale mechanism and the fiscal budget constraint that may or may not restrain the policy authorities from infusing money to halt the contagion. The modelling framework could be used both as a crisis management tool to help inform decisions on capital/liquidity infusions in the context of resolutions and precautionary recapitalizations or as a crisis prevention tool to help calibrate capital buffer requirements to address systemic risks due to interconnectedness.

Keywords: Interbank networks; Contagion; Fire sales; Stress testing; Macroprudential policy; Optimal control (search for similar items in EconPapers)
JEL-codes: C61 D85 G01 G18 G21 G28 L14 (search for similar items in EconPapers)
Date: 2024
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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Working Paper: On the optimal control of interbank contagion in the euro area banking system (2021)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:finsta:v:71:y:2024:i:c:s157230892400010x

DOI: 10.1016/j.jfs.2024.101225

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