The global financial crisis of 2007-08 left governments facing a major dilemma; should they offer financial assistance to distressed banks in the form of a bailout, or leave them to go bankrupt and face the systemic consequences for the rest of the economy. The decisionproblem about bailout has traditionally been viewed as a trade-off between the regulators’ preference for minimising either moral hazard or contagion and there is an extensive game-theoretic literature. However, studies in this domain are typically confined to strict equilibrium analysis of settings with very few actors.
Hence, these models lack a detailed analysis of the true systemic risk within the interbank market, as they fail to capture heterogeneity in network structure and bank size. The need for a better understanding of systemic risk has led to a dramatic rise in literature analysingcontagion using percolation techniques. Recent models have introduced dynamic interbank networks and multiple contagion channels, which allow the market dynamics of a bankruptcy to be studied. However, whilst these models allow an analysis of cascading dynamics in the short term, they are not suitable for analysing the effect of bankruptcy resolution policy in the long term as they assume banks’ risk appetites to be fixed rather than adaptive, meaning that no moral hazard effect be captured in the system.
This project proposes to combine both traditional strands of the literature to develop simulation models of bank behaviour in networked settings. Building on a recent study of moral hazard effects and bailout in very abstract simplified networked banking systems it will extend the work to include: (i) more realistic game theoretical descriptions of bank behaviour, (ii) a more detailed description of contagion channels of financial distress using multi-layered network approaches, and (iii) considerations of network dynamics as banks rearrange their risk exposures during crises.
If you wish to discuss any details of the project informally, please contact Markus Brede, AIC research group, Email:[email protected] , Tel: +44 (0) 2380 59 3703.