Please use this identifier to cite or link to this item: https://hdl.handle.net/10419/237693 
Year of Publication: 
2021
Series/Report no.: 
ECB Working Paper No. 2554
Publisher: 
European Central Bank (ECB), Frankfurt a. M.
Abstract: 
In this paper we present a methodology of model-based calibration of additional capital needed in an interconnected financial system to minimize potential contagion losses. Building on ideas from combinatorial optimization tailored to controlling contagion in case of complete information about an interbank network, we augment the model with three plausible types of fire sale mechanisms. We then demonstrate the power of the methodology on the euro area banking system based on a network of 373 banks. On the basis of an exogenous shock leading to defaults of some banks in the network, we find that the contagion losses and the policy authority's ability to control them depend on the assumed fire sale mechanism and the fiscal budget constraint that may or may not restrain the policy authorities from infusing money to halt the contagion. The modelling framework could be used both as a crisis management tool to help inform decisions on capital/liquidity infusions in the context of resolutions and precautionary recapitalisations or as a crisis prevention tool to help calibrate capital buffer requirements to address systemic risks due to interconnectedness.
Subjects: 
Interbank networks
contagion
re sales
stress testing
macroprudential policy
optimal control
JEL: 
C61
D85
G01
G18
G21
G28
L14
Persistent Identifier of the first edition: 
ISBN: 
978-92-899-4554-7
Document Type: 
Working Paper

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