Anticipated Financial Contagion

Toni Ahnert, Gideon DuRand and Co-Pierre Georg

No 18223, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: We examine the incidence of financial contagion, bank choices, welfare, and regulation when interconnected banks anticipate an aggregate liquidity shock. Revisiting the seminal paper of Allen and Gale (2000), interbank deposits allow banks to co-insure against regional liquidity shocks but can also lead to contagion—the mutual default of banks. We numerically characterize the equilibrium and find that contagion is rare. Moreover, the equilibrium is constrained inefficient. For less likely aggregate liquidity shocks, banks hold inefficiently large interbank positions that over-expose surviving banks to impaired returns from failing banks when resolution occurs at market values. Efficiency can be restored via an alternative bank resolution scheme.

Keywords: Financial; contagion (search for similar items in EconPapers)
JEL-codes: G01 G11 G21 (search for similar items in EconPapers)
Date: 2023-06
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Working Paper: Anticipated Financial Contagion (2019)
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