Working Paper: CEPR ID: DP18223
Authors: Toni Ahnert; Gideon Durand; Copierre Georg
Abstract: We examine the incidence of financial contagion, bank choices, welfare, and regulation when interconnected banks anticipate an aggregate liquidity shock. Revisiting the seminal paper of Allen and Gale (2000), interbank deposits allow banks to co-insure against regional liquidity shocks but can also lead to contagion—the mutual default of banks. We numerically characterize the equilibrium and find that contagion is rare. Moreover, the equilibrium is constrained inefficient. For less likely aggregate liquidity shocks, banks hold inefficiently large interbank positions that over-expose surviving banks to impaired returns from failing banks when resolution occurs at market values. Efficiency can be restored via an alternative bank resolution scheme.
Keywords: financial contagion; demand deposits; interbank deposits; aggregate liquidity shock; computational equilibrium
JEL Codes: G01; G11; G21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| size of aggregate liquidity shock (E44) | banks' ex ante choices (G21) |
| probability of aggregate liquidity shock (E44) | banks' ex ante choices (G21) |
| aggregate liquidity shock (E44) | financial contagion (F65) |
| inefficiently large interbank positions (F65) | constrained inefficiency (D61) |
| resolution at market values (G19) | efficiency restoration (D61) |