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Optimal Control of Interbank Contagion under Complete Information
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BibTeX
@MISC{Minca_optimalcontrol,
author = {Andreea Minca},
title = {Optimal Control of Interbank Contagion under Complete Information},
year = {}
}
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Abstract
We study a preferred equity infusion government program set to mitigate inter-bank contagion. Financial institutions are prone to insolvency risk channeled through the network of interbank debt and to the risk of bank runs. The government seeks to maximize, under budget constraints, the total net worth of the financial system or, equivalently, to minimize the dead-weight losses induced by bank runs. The government is assumed to have complete information on interbank debt. The problem of quantifying the optimal amount of infusions can be expressed as a convex combinatorial optimiza-tion problem, tractable when the set of banks eligible for intervention (core banks) is sufficiently, yet realistically, small. We find that no bank has an incentive to withdraw from the program, when the preferred dividend rate paid to the government is equal to the government’s outside return on the intervention budget. On the other hand, it may be optimal for the government to make infusions in a strict subset of core banks.
Keyphrases
complete information interbank contagion optimal control interbank debt core bank bank run outside return convex combinatorial optimiza-tion problem strict subset budget constraint optimal amount financial institution inter-bank contagion intervention budget dead-weight loss financial system total net worth preferred dividend rate preferred equity infusion government program
