Central bank in a contagion model

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We propose an innovative way to assess central banks interventions by introducing a central bank in the contagion model proposed by Greenwood, Landier, and Thesmar
(2015). In a theoretical study, with two banks and one asset, we show that the total amount spent by the central bank to purchase banks assets to lower systemic risk
should be allocated to the bank with the higher leverage ratio. With two banks owning two assets in different proportions, this amount increases with respect to both bank’s leverage ratio and size. Our framework is then applied to European banks during the sovereign debt crisis to assess three unconventional monetary policies. We find that a capital injection policy is the most efficient but costly. The Long Term Refinancing Operation provokes an increase of the amount of assets sold by banks and of systemic risk as well. However, assets purchase as a monetary policy is beneficial, especially when the central bank buys sovereign debts.

Author(s):

Maroua Riabi    
Paris Dauphine University
France