Optimal Control of Interbank Contagion Under Complete Information

25 Pages Posted: 30 Aug 2013 Last revised: 3 Nov 2014

Andreea Minca

Cornell University

Agnes Sulem

French National Institute for Research in Computer Science and Control (INRIA)

Date Written: December 28, 2013

Abstract

We study a preferred equity infusion government program set to mitigate interbank contagion. Financial institutions are prone to insolvency risk channeled through the network of interbank debt and to the risk of bank runs. The government seeks to maximize, under budget constraints, the total net worth of the financial system or, equivalently, to minimize the dead-weight losses induced by bank runs. The government is assumed to have complete information on interbank debt. The problem of quantifying the optimal amount of infusions can be expressed as a convex combinatorial optimization problem, tractable when the set of banks eligible for intervention (core banks) is sufficiently, yet realistically, small.

We find that no bank has an incentive to withdraw from the program, when the preferred dividend rate paid to the government is equal to the government's outside rate of return on the intervention budget. On the other hand, it may be optimal for the government to make infusions in a strict subset of core banks.

Keywords: Systemic risk, Liquidity risk, Bank runs, Financial contagion, Financial Networks, Optimal Intervention, , Bail-outs

JEL Classification: C6, G18, G21, G28, G33

Suggested Citation

Minca, Andreea and Sulem, Agnes, Optimal Control of Interbank Contagion Under Complete Information (December 28, 2013). Available at SSRN: https://ssrn.com/abstract=2317516 or http://dx.doi.org/10.2139/ssrn.2317516

Andreea Minca (Contact Author)

Cornell University ( email )

222 Rhodes Hall
Ithaca, NY NY 14853
United States

HOME PAGE: http://people.orie.cornell.edu/acm299/

Agnes Sulem

French National Institute for Research in Computer Science and Control (INRIA) ( email )

40 avenue Halley
Villeneuve, 59650
France

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