Author(s):
Toni Ahnert, Gideon DuRand, Co-Pierre Georg
Date:
June 2023
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.
Link: CEPR Press Discussion Paper No. 18223 – Anticipated Financial Contagion