Interbank Contagion and Resolution Procedures: Inspecting the Mechanism

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.

Keywords: Systemic Risk, Banking Network, Resolution Procedures

JEL Classification: D85, G28, G33