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Interbank contagion and resolution procedures: inspecting the mechanism

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  • Edoardo Gaffeo

    ()

  • Massimo Molinari

    ()

Abstract

This paper develops a network model of a stylized banking system in which banks are connected to one another through interbank claims, which allows us to study the diffusion of default avalanches triggered by an exogenous shock under a number of different assumptions on the degree of interconnectedness, level of capitalization, liquidity buffers, the size of the interbank market and fire-sales. We expand upon the existing literature by embedding two alternative resolution mechanisms. First, liquidations triggered by either illiquidity or insolvency-related distress implying asset sales and compensation of creditors. Second, a bail-in mechanism avoiding bank closure by forcing a recapitalization provided by bank creditors. Our model speaks to how contagion dynamics unravel via illiquidity-driven defaults in the first case and higher-order losses in the latter one. Within this framework, we show how counter-party liquidity risk externality can be resolved and put forward a macro-criterion to assess the adequacy of the liquidity ratio introduced with Basel III.

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Bibliographic Info

Paper provided by Department of Economics and Management in its series DEM Discussion Papers with number 2013/09.

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Date of creation: 2013
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Handle: RePEc:trn:utwpem:2013/09

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Keywords: Systemic Risk; Banking Network; Resolution Procedures;

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References

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  1. Edoardo Gaffeo & Roberto Tamborini, 2011. "If the Financial System Is Complex, How Can We Regulate It?," International Journal of Political Economy, M.E. Sharpe, Inc., vol. 40(2), pages 79-97, July.
  2. Enrico Perotti & Javier Suarez, 2011. "A Pigovian Approach to Liquidity Regulation," DNB Working Papers 291, Netherlands Central Bank, Research Department.
  3. Sachs, Angelika, 2010. "Completeness, interconnectedness and distribution of interbank exposures: A parameterized analysis of the stability of financial networks," Discussion Paper Series 2: Banking and Financial Studies 2010,08, Deutsche Bundesbank, Research Centre.
  4. Gai, Prasanna & Haldane, Andrew & Kapadia, Sujit, 2011. "Complexity, concentration and contagion," Journal of Monetary Economics, Elsevier, vol. 58(5), pages 453-470.
  5. Battiston, Stefano & Delli Gatti, Domenico & Gallegati, Mauro & Greenwald, Bruce & Stiglitz, Joseph E., 2012. "Liaisons dangereuses: Increasing connectivity, risk sharing, and systemic risk," Journal of Economic Dynamics and Control, Elsevier, vol. 36(8), pages 1121-1141.
  6. James, Christopher, 1991. " The Losses Realized in Bank Failures," Journal of Finance, American Finance Association, vol. 46(4), pages 1223-42, September.
  7. Iori, Giulia & Jafarey, Saqib & Padilla, Francisco G., 2006. "Systemic risk on the interbank market," Journal of Economic Behavior & Organization, Elsevier, vol. 61(4), pages 525-542, December.
  8. Upper, Christian, 2011. "Simulation methods to assess the danger of contagion in interbank markets," Journal of Financial Stability, Elsevier, vol. 7(3), pages 111-125, August.
  9. Daron Acemoglu & Asuman Ozdaglar & Alireza Tahbaz-Salehi, 2013. "Systemic Risk and Stability in Financial Networks," NBER Working Papers 18727, National Bureau of Economic Research, Inc.
  10. Viral V. Acharya & Hyun Song Shin & Tanju Yorulmazer, 2011. "Crisis Resolution and Bank Liquidity," Review of Financial Studies, Society for Financial Studies, vol. 24(6), pages 2166-2205.
  11. Krause, Andreas & Giansante, Simone, 2012. "Interbank lending and the spread of bank failures: A network model of systemic risk," Journal of Economic Behavior & Organization, Elsevier, vol. 83(3), pages 583-608.
  12. repec:dgr:uvatin:2011040 is not listed on IDEAS
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Cited by:
  1. Edoardo Gaffeo & Massimo Molinari, 2014. "Macroprudential Consolidation Policy in Interbank Networks," DEM Discussion Papers 2014/01, Department of Economics and Management.

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