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

Arbeitspapier

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.

Object Details

• ISBN: 978-92-899-4554-7
• Language: Englisch

References and Relationships

• Bibliographic citation: Series: ECB Working Paper ; No. 2554

Classification and Topics

• Classification: Wirtschaft ; Optimization Techniques; Programming Models; Dynamic Analysis ; Network Formation and Analysis: Theory ; Financial Crises ; General Financial Markets: Government Policy and Regulation ; Banks; Depository Institutions; Micro Finance Institutions; Mortgages ; Financial Institutions and Services: Government Policy and Regulation ; Transactional Relationships; Contracts and Reputation; Networks
• Subject: Interbank networks ; contagion ; re sales ; stress testing ; macroprudential policy ; optimal control

Contributors, Places and Time

• Event: Geistige Schöpfung
• (who): Fukker, Gábor ; Kok Sørensen, Christoffer
• Event: Veröffentlichung
• (who): European Central Bank (ECB)
• (where): Frankfurt a. M.
• (when): 2021

Further information

• DOI: doi:10.2866/223229
• Handle: http://hdl.handle.net/10419/237693
• Last update: 10.03.2025, 11:45 AM CET