Optimal Bailouts in Diversified Financial Networks

TL;DR

This paper investigates optimal bailout strategies in diversified financial networks, demonstrating that simple, targeted policies can effectively minimize capital injections while ensuring solvency, especially in core-periphery structures.

Contribution

It introduces a tractable approach for optimal bailouts in complex networks, leveraging network structure to simplify decision-making.

Findings

Optimal bailout policies can be implemented via simple targeting strategies.

Targeted bailouts significantly reduce total capital injections.

Effective strategies are identified for core-periphery network structures.

Abstract

Widespread default involves substantial deadweight costs which could be countered by injecting capital into failing firms. Injections have positive spillovers that can trigger a repayment cascade. But which firms should a regulator bailout so as to minimize the total injection of capital while ensuring solvency of all firms? While the problem is, in general, NP-hard, for a wide range of networks that arise from a stochastic block model, we show that the optimal bailout can be implemented by a simple policy that targets firms based on their characteristics and position in the network. Specific examples of the setting include core-periphery networks.