Control of Dynamic Financial Networks (The Extended Version)

TL;DR

This paper presents a linear programming approach to strategically inject cash into a financial network to reduce contagion and prevent cascading defaults, enhancing systemic stability.

Contribution

It introduces a dynamic control model for financial networks that efficiently determines targeted interventions to mitigate contagion effects.

Findings

Targeted cash injections significantly reduce default propagation.

The control model is computationally efficient and scalable.

Numerical examples demonstrate effective contagion mitigation.

Abstract

The current global financial system forms a highly interconnected network where a default in one of its nodes can propagate to many other nodes, causing a catastrophic avalanche effect. In this paper we consider the problem of reducing the financial contagion by introducing some targeted interventions that can mitigate the cascaded failure effects. We consider a multi-step dynamic model of clearing payments and introduce an external control term that represents corrective cash injections made by a ruling authority. The proposed control model can be cast and efficiently solved as a linear program. We show via numerical examples that the proposed approach can significantly reduce the default propagation by applying small targeted cash injections.