Stabilizing financial networks via mergers and acquisitions

A bi-level model is proposed to explore efficient policies for supporting negotiations on financial crisis resolution. In a principal–agent framework, this model minimizes the welfare loss function of a central authority (social planner, SP) through the simultaneous choice of subsidy levels and potential pairs of banks to merge. The SP’s choice of mergers needs to be incentive-compatible with the autonomous choices of banks, and the evaluation of the financial network must adhere to standard accounting principles. Incentive compatibility is enforced by two options for conditions, based on stable matching or competitive bidding. For the evaluation of the financial network, we employ an extended Eisenberg–Noe clearing payment equilibrium by considering bankruptcy costs and the seniority levels of liabilities. Additionally, liabilities are not cleared among solvent banks, and corporate bonds may be used for clearing payments. The bi-level model specifies conditions for the clearing equilibrium. For demonstration, we use major European banks, and a scenario linked to the adverse economic conditions used in the 2016 EU-wide stress testing.