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Financial Contagion through Capital Connections: A Model of the Origin and Spread of Bank Panics

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  • Amil Dasgupta

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    Abstract

    Financial 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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    File URL: http://www.lse.ac.uk/fmg/workingPapers/discussionPapers/fmgdps/DP436.pdf
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    Bibliographic Info

    Paper provided by Financial Markets Group in its series FMG Discussion Papers with number dp436.

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    Date of creation: Nov 2002
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    Handle: RePEc:fmg:fmgdps:dp436

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    Web page: http://www.lse.ac.uk/fmg/

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    Cited by:
    1. Christian Hellwig, 2004. "Dynamic Global Games of Regime Change: Learning, Multiplicity and Timing of Attacks (August 2006, with George-Marios Angeletos and Alessandro Pavan)," UCLA Economics Online Papers 279, UCLA Department of Economics.
    2. Hassan Naqvi, 2004. "Banking Crises and the Lender of Last Resort: How crucial is the role of information?," Finance 0410009, EconWPA.

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