Bank Capital, Interbank Contagion and Bailout Cost

This paper develops a theoretical framework in which contagion due to asset linkages arising from a syndicated loan agreement may infect other healthy banks when a partner bank fails. We calibrate the process other banks go through in adjusting their optimal capital-asset ratio when they make choices between liquidating its investment in a joint project or taking over a failed partner’s loan. We examine the impacts of banks’ asset allocation, asset correlation, and the regulatory capital requirements on the re-adjusted capital-asset ratio, which determines banks’ optimal responses, survival likelihood, and government bailout cost. This study provides a possible operation tool to evaluate interbank contagion and theoretical support for the recently passed Basel III calling for banks to raise capital ratios.