The Optimal Bailout Policy in an Interbank Network

This paper introduces a theoretical model to analyze the optimal bailout policy in an inter-connected banking system. The model intends to highlight two motivations behind providing a partial bailout to banks in distress: prevention of costly bankruptcies and prevention of financial contagion. In the extreme cases where the cost of bailout is sufficiently high or low, the zero-bailout policy or the full-bailout policy is optimal respectively. Otherwise, a partial bailout policy is optimal. The fiscal authority has to balance the benefits of bailouts from bankruptcy and contagion prevention against the cost when it decides on the amount of partial bailout to provide to banks