Optimal bailout strategies resulting from the drift controlled supercooled Stefan problem

Christa Cuchiero, Christoph Reisinger and Stefan Rigger

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Abstract: We consider the problem faced by a central bank which bails out distressed financial institutions that pose systemic risk to the banking sector. In a structural default model with mutual obligations, the central agent seeks to inject a minimum amount of cash in order to limit defaults to a given proportion of entities. We prove that the value of the central agent's control problem converges as the number of defaultable institutions goes to infinity, and that it satisfies a drift controlled version of the supercooled Stefan problem. We compute optimal strategies in feedback form by solving numerically a regularized version of the corresponding mean field control problem using a policy gradient method. Our simulations show that the central agent's optimal strategy is to subsidise banks whose equity values lie in a non-trivial time-dependent region.

Date: 2021-11, Revised 2022-10
New Economics Papers: this item is included in nep-ban and nep-rmg
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