The evolution of risk and bailout strategy in banking systems

Authored by Markus Brede, Frank McGroarty, Caux Robert De

Date Published: 2017

DOI: 10.1016/j.physa.2016.10.005

Sponsors: United Kingdom Engineering and Physical Sciences Research Council (EPSRC)

Platforms: No platforms listed

Model Documentation: Other Narrative Mathematical description

Model Code URLs: Model code not found

Abstract

In this paper we analyse the long-term costs and benefits of bailout strategies in models of networked banking systems. Unlike much of the current literature on financial contagion that focuses on systemic risk at one point in time, we consider adaptive banks that adjust risk taking in response to internal system dynamics and regulatory intervention, allowing us to analyse the potentially crucial moral hazard aspect associated with frequent bailouts. We demonstrate that whereas bailout generally serves as an effective tool to limit the size of bankruptcy cascades in the short term, inappropriate intervention strategies can encourage risk-taking and thus be inefficient and detrimental to long term system stability. We analyse points of long-term optimal bailout and discuss their dependence on the structure of the banking network. In the second part of the paper, we demonstrate that bailout efficiency can be improved by taking into account information about the topology of and risk allocation on the banking network, and demonstrate that finely tuned intervention strategies aimed at bailing out banks in configurations with some degree of anti-correlated risk have superior performance. These results demonstrate that a suitable intervention policy may be a useful tool for driving the banking system towards a more robust structure. (C) 2016 Elsevier B.V. All rights reserved.

Tags

Agent-based model Simulation Liquidity networks Model Contagion Financial contagion Bank insolvency Evolutionary game theory