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Interbank contagion and resolution procedures: inspecting the mechanism

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  • Edoardo Gaffeo

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  • Massimo Molinari

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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.

Suggested Citation

  • Edoardo Gaffeo & Massimo Molinari, 2013. "Interbank contagion and resolution procedures: inspecting the mechanism," DEM Discussion Papers 2013/09, Department of Economics and Management.
  • Handle: RePEc:trn:utwpem:2013/09
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    References listed on IDEAS

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    1. 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.
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    6. Michele Manna & Carmela Iazzetta, 2009. "The topology of the interbank market: developments in Italy since 1990," Temi di discussione (Economic working papers) 711, Bank of Italy, Economic Research and International Relations Area.
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    Cited by:

    1. E. Gaffeo & M. Molinari, 2016. "Macroprudential consolidation policy in interbank networks," Journal of Evolutionary Economics, Springer, vol. 26(1), pages 77-99, March.
    2. Edoardo Gaffeo & Massimo Molinari, 2016. "A functional perspective to financial networks," DEM Working Papers 2016/06, Department of Economics and Management.

    More about this item

    Keywords

    Systemic Risk; Banking Network; Resolution Procedures;

    JEL classification:

    • D85 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Network Formation
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation

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