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Bailouts in Financial Networks

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  • Beni Egressy
  • Roger Wattenhofer

Abstract

We consider networks of banks with assets and liabilities. Some banks may be insolvent, and a central bank can decide which insolvent banks, if any, to bail out. We view bailouts as an optimization problem where the central bank has given resources at its disposal and an objective it wants to maximize. We show that under various assumptions and for various natural objectives this optimization problem is NP-hard, and in some cases even hard to approximate. Furthermore, we also show that given a fixed central bank bailout objective, banks in the network can make new debt contracts to increase their own market value in the event of a bailout (at the expense of the central bank).

Suggested Citation

  • Beni Egressy & Roger Wattenhofer, 2021. "Bailouts in Financial Networks," Papers 2106.12315, arXiv.org.
    • Handle: RePEc:arx:papers:2106.12315
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    References listed on IDEAS

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    1. Brett Hemenway & Sanjeev Khanna, 2016. "Sensitivity and computational complexity in financial networks," Algorithmic Finance, IOS Press, vol. 5(3-4), pages 95-110.
    2. Paul Glasserman & H. Peyton Young, 2016. "Contagion in Financial Networks," Journal of Economic Literature, American Economic Association, vol. 54(3), pages 779-831, September.
    3. Glasserman, Paul & Young, H. Peyton, 2015. "How likely is contagion in financial networks?," Journal of Banking & Finance, Elsevier, vol. 50(C), pages 383-399.
    4. Benjamin Bernard & Agostino Capponi & Joseph E. Stiglitz, 2022. "Bail-Ins and Bailouts: Incentives, Connectivity, and Systemic Stability," Journal of Political Economy, University of Chicago Press, vol. 130(7), pages 1805-1859.
    5. Glasserman, Paul & Young, H. Peyton, 2016. "Contagion in financial networks," LSE Research Online Documents on Economics 68681, London School of Economics and Political Science, LSE Library.
    6. P'al Andr'as Papp & Roger Wattenhofer, 2020. "Default Ambiguity: Finding the Best Solution to the Clearing Problem," Papers 2002.07741, arXiv.org, revised Oct 2021.
    7. Paul Glasserman & Peyton Young, 2015. "Contagion in Financial Networks," Economics Series Working Papers 764, University of Oxford, Department of Economics.
    8. Brett Hemenway & Sanjeev Khanna, 2015. "Sensitivity and Computational Complexity in Financial Networks," Papers 1503.07676, arXiv.org, revised Oct 2016.
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    Cited by:

    1. Matthew O Jackson & Agathe Pernoud, 2024. "Credit Freezes, Equilibrium Multiplicity, and Optimal Bailouts in Financial Networks," The Review of Financial Studies, Society for Financial Studies, vol. 37(7), pages 2017-2062.

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