Abstract

We analyze the stability of an interbank network, in which rescues in the form of subsidized bail-ins or public bailouts can be coordinated to stop financial contagion. The coordination of a rescue consortium between a benevolent social planner and the banks is modeled as a sequential game. We show that the equilibrium welfare losses are generically unique, depending heavily on whether or not the social planner’s threat to not intervene is credible. We provide conditions under which the threat is credible and characterize the optimal intervention plan. Our analysis shows that sparsely connected networks may enhance financial stability in two ways: (i) a smaller amplification of the shock under no-intervention may enhance credibility of the social planner’s threat and (ii), because default resolution costs are concentrated, the creditors of defaulting banks can be incentivized to make large contributions to a subsidized bail-in. This may make a sparsely connected network socially preferable over a more densely connected network, even if the densely connected network was financially more stable in the absence of any intervention.