Cooperative resolution of crises in financial networks

Abstract

Since the beginning of the financial crisis in 2007-2008, several mitigation policies have been considered to monitor and stabilize the financial system in the event of a shock. We examine the financial network of systemically important banks as a cooperative game. Governments can act as facilitators, enforcing incentives for banks to cooperate in voluntary bail-ins and prevent the escalation of the financial crisis. To incentivize the formation of a cooperative consortium, we consider (i) a threat tax on equity in case a cooperative rescue fails and (ii) assisted bail-ins, in which the regulator promises some financial support. To evaluate the characteristic function of the cooperative game, we employ a clearing payment model for alternative coalitions competing in the market. As a fair division concept, we use the proportional nucleolus which implies a possible subsidizing pattern among the banks. Group rationality requires the tax to exceed a minimum tax level that we introduce. While the tax is assumed fixed before the crisis starts, the regulator may find a minimal public subsidy to meet such group rationality requirement. For a demonstration, we used major European banks and scenarios that are linked to the adverse economic scenario used in the EU-wide stress testing of 2016.