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The evolution of risk and bailout strategy in banking systems

The evolution of risk and bailout strategy in banking systems
The evolution of risk and bailout strategy in banking systems
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.
0378-4371
109-118
De Caux, Robert
a3e6d29e-ed87-4803-b08d-36392c5bf1dd
Mcgroarty, Frank
693a5396-8e01-4d68-8973-d74184c03072
Brede, Markus
bbd03865-8e0b-4372-b9d7-cd549631f3f7
De Caux, Robert
a3e6d29e-ed87-4803-b08d-36392c5bf1dd
Mcgroarty, Frank
693a5396-8e01-4d68-8973-d74184c03072
Brede, Markus
bbd03865-8e0b-4372-b9d7-cd549631f3f7

De Caux, Robert, Mcgroarty, Frank and Brede, Markus (2017) The evolution of risk and bailout strategy in banking systems. Physica A: Statistical Mechanics and its Applications, 468, 109-118. (doi:10.1016/j.physa.2016.10.005).

Record type: Article

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.

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Evolution of risk (Physica A).pdf - Accepted Manuscript
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Accepted/In Press date: 2 October 2016
e-pub ahead of print date: 18 October 2016
Published date: 15 February 2017
Organisations: Agents, Interactions & Complexity, Southampton Business School

Identifiers

Local EPrints ID: 403085
URI: http://eprints.soton.ac.uk/id/eprint/403085
ISSN: 0378-4371
PURE UUID: 77ef49a0-87fa-4cc0-90a4-61bf044316ef
ORCID for Frank Mcgroarty: ORCID iD orcid.org/0000-0003-2962-0927

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Date deposited: 23 Nov 2016 15:16
Last modified: 07 Oct 2020 06:23

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