Anticipated Financial Contagion

Abstract

How likely is financial contagion when banks anticipate an aggregate liquidity shock and what are the consequences for bank choices, welfare, and regulation? We study an economy with two regional banks that insure risk-averse consumers against their idiosyncratic liquidity shocks and hold interbank deposits to co-insure against regional liquidity shocks. An aggregate liquidity shock hits one of the banks with positive probability and can lead to contagion---the mutual default of banks. We numerically characterize the equilibrium and show that contagion is rare: it occurs in approximately 5% of the parameter space and its ex-ante probability is below 1%. For likely aggregate liquidity shocks, the decentralized economy achieves the same expected utility as a global bank benchmark, which we fully characterize analytically. For less likely liquidity shocks, the economy is constrained inefficient. To shield themselves from contagion, banks hold inefficiently low interbank positions (co-insurance) and excessive liquidity (self-insurance). Efficiency is restored via an alternative bank resolution scheme.

Keywords: Demand deposits, interbank deposits, aggregate liquidity shock, financial contagion, computational equilibrium

JEL Classification: G01, G11, G21