Financial contagion through capital connections: a model of the origin and spread of bank panics
AbstractFinancial contagion is modeled as an equilibrium phenomenon in a dynamic setting with incomplete information and multiple banks. The equilibrium probability of bank failure is uniquely determined. We explore how the cross holding of deposits motivated by imperfectly correlated regional liquidity shocks can lead to contagious effects conditional on the failure of a financial institution. We show that contagion is possible in the unique equilibrium of the economy and characterize exactly when it may exist. At the same time, we identify a direction of flow for contagious effects, which provides a rationale for localized financial panics. Simulations identify the optimal level of interbank deposit holdings in the presence of contagion risk. Our results suggest that when the probability of bank failure is low, maximal levels of interbank holdings are optimal. When cross holding of deposits is complete, we demonstrate that the intensity of contagion is increasing in the size of regionally aggregate liquidity shocks.
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Bibliographic InfoPaper provided by London School of Economics and Political Science, LSE Library in its series LSE Research Online Documents on Economics with number 24956.
Length: 34 pages
Date of creation: Nov 2002
Date of revision:
Bank panics; Contagion; Equilibrium selection; Global games;
Find related papers by JEL classification:
- C7 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory
- G2 - Financial Economics - - Financial Institutions and Services
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