Fragility, Rescues, and Stability in Financial Networks
72 Pages Posted: 24 Oct 2017 Last revised: 2 Nov 2021
Date Written: September 24, 2021
This paper presents a coalitional rescue framework in financial networks, where banks’ potential losses from failures incentivize them to rescue each other and a welfare-losses-minimizing government contributes to rescues via bailout transfers. Endogenous rescues reverse fundamental insights into financial networks and provide general insights into how interconnected agents behave differently against each other’s fragility and how the government can reduce welfare-losses via a combination of ex-ante policies and ex-post transfers. Surprisingly, for any particular bank, the government’s bailout decision is independent of contagious effects (or the whole network structure) and depends only on the direct costs and benefits of its rescue (or local connectivity). Therefore, rescues occur selectively. Nevertheless, a network-neutrality result holds: In any financial network (under a mild condition), the government always prevents certain types of failures. Despite the network-neutrality in rescue decisions, banks’ contributions in rescues and the welfare losses vary dramatically depending on the network structure. I characterize welfare-losses-minimizing networks and introduce a new concept: “self-contained networks”, which applies to different settings beyond financial networks.
Keywords: bail-ins, bailouts, coalition formation, financial contagion, financial networks, financial stability, interbank regulations, rescue mergers.
JEL Classification: C72, D85, G28, G34, H81.
Suggested Citation: Suggested Citation