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Anticipated Financial Contagion

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  • Ahnert, Toni
  • DuRand, Gideon
  • Georg, Co-Pierre

Abstract

We examine the incidence of financial contagion, bank choices, welfare, and regulation when interconnected banks anticipate an aggregate liquidity shock. Revisiting the seminal paper of Allen and Gale (2000), interbank deposits allow banks to co-insure against regional liquidity shocks but can also lead to contagion—the mutual default of banks. We numerically characterize the equilibrium and find that contagion is rare. Moreover, the equilibrium is constrained inefficient. For less likely aggregate liquidity shocks, banks hold inefficiently large interbank positions that over-expose surviving banks to impaired returns from failing banks when resolution occurs at market values. Efficiency can be restored via an alternative bank resolution scheme.

Suggested Citation

  • Ahnert, Toni & DuRand, Gideon & Georg, Co-Pierre, 2023. "Anticipated Financial Contagion," CEPR Discussion Papers 18223, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:18223
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    More about this item

    Keywords

    Financial contagion;

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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