Optimal bailout strategies and the drift controlled supercooled Stefan problem

28 October 2021

We consider the problem faced by a central bank which bails out distressed financial institutions that pose systemic risk to the banking sector. In a structural default model with mutual obligations, the central agent seeks to inject a minimum amount of cash to a subset of the entities in order to limit defaults to a given proportion of entities. We prove that the value of the agent's control problem converges as the number of defaultable agents goes to infinity, and it satisfies  a drift controlled version of the supercooled Stefan problem. We compute optimal strategies in feedback form by solving numerically a forward-backward coupled system of PDEs. Our simulations show that the agent's optimal strategy is to subsidise banks whose asset values lie in a non-trivial time-dependent region. Finally, we study a linear-quadratic version of the model where instead of the losses, the agent optimises a terminal loss function of the asset values. In this case, we are able to give semi-analytic strategies, which we again illustrate numerically. Joint work with Christa Cuchiero and Stefan Rigger.

  • Mathematical and Computational Finance Internal Seminar