Optimal Support for Distressed Subsidiaries -- a Systemic Risk Perspective

TL;DR

This paper analyzes how holding structures in banking networks influence systemic risk and contagion, showing that support levels can either mitigate or amplify financial stress depending on network capitalization.

Contribution

It introduces a multilayered network model of bank holdings and subsidiaries, analyzing contagion spread and optimal support levels for systemic stability.

Findings

Holding structures can reduce contagion in well-capitalized networks.

Support levels significantly impact the extent of financial contagion.

Optimal support levels depend on network capitalization and resilience.

Abstract

We consider a network of bank holdings, where every holding has two subsidiaries of different types. A subsidiary can trade with another holding's subsidiary of the same type. Holdings support their subsidiaries up to a certain level when they would otherwise fail to honor their financial obligations. We investigate the spread of contagion in this banking network when the number of bank holdings is large, and find the final number of defaulted subsidiaries under different rules for the holding support. We also consider resilience of this multilayered network to small shocks. Our work sheds light onto the role that holding structures can play in the amplification of financial stress. We find that depending on the capitalization of the network, a holding structure can be beneficial as compared to smaller separated entities. In other instances, it can be harmful and actually increase contagion. We illustrate our results in a numerical case study and also determine the optimal level of holding support from a regulator perspective.