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

Gabor Fukker () and Christoffer Kok

No 2554, Working Paper Series from European Central Bank

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 recapitalisations or as a crisis prevention tool to help calibrate capital buffer requirements to address systemic risks due to interconnectedness. JEL Classification: C61, D85, G01, G18, G21, G28, L14

Keywords: contagion; fire sales; interbank networks; macroprudential policy; optimal control; stress testing (search for similar items in EconPapers)
Date: 2021-05
New Economics Papers: this item is included in nep-ban, nep-cba, nep-eec, nep-mon and nep-net
Note: 508948
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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Journal Article: On the optimal control of interbank contagion in the euro area banking system (2024)
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Persistent link: https://EconPapers.repec.org/RePEc:ecb:ecbwps:20212554

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