On the Optimal Control of Interbank Contagion in the Euro Area Banking System

In this paper we present a methodology of model-based calibration additional capital needed in an interconnected financial system to minimize potential contagion losses. Building on ideas from combinatorial optimization tailored controlling case complete information about interbank network, augment the model with three plausible types fire sale mechanisms. We then demonstrate power euro area banking based network 373 banks. On basis exogenous shock leading defaults some banks find that losses and policy authority's ability control them depend assumed mechanism fiscal budget constraint may or not restrain authorities infusing money halt contagion. The modelling framework could be used both as crisis management tool help inform decisions capital/liquidity infusions context resolutions precautionary recapitalisations prevention calibrate buffer requirements address systemic risks due interconnectedness. JEL Classification: C61, D85, G01, G18, G21, G28, L14