Download This PaperFrom Lombard Street to Wall Street: Systemic Risk, Rescues, and Stability in Financial Networks
46 Pages Posted: 24 Oct 2017 Last revised: 2 Nov 2021
Date Written: September 24, 2021
Abstract
This paper studies optimal government interventions in financial networks under the bail-ins policy, where regulators can write down the interbank debts of distressed banks, effectively making banks contribute to rescuing each other to prevent costly failures. We introduce a model capturing the contrasting effects of interbank debts: they allow for cost-sharing among banks but also create fragility via potential cascades of failures. Bail-ins and complementary bailouts are costly. We find that welfare gains from the bail-ins policy are maximized under intermediate levels of debts that are maximally diversified across banks. Against large shocks, the regulator lets initially affected banks fail and focuses on limiting contagion. Diversification helps contain cascades, eliminating the need for further bail-ins. However, when the extent of initial distress is uncertain, there is a trade-off of interbank debt levels. Then, optimal debt levels depend on the welfare costs of bail-ins and bailouts, balancing these trade-offs under different shock scenarios.
Keywords: bail-ins, bailouts, coalition formation, financial contagion, financial networks, financial stability, interbank regulations, rescue mergers.
JEL Classification: C72, D85, G28, G34, H81.
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