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Contagion in Financial Markets

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Author Info

  • David Backus

    (New York University)

  • Silverio Foresi

    (Goldman Sachs)

  • Liuren Wu

    (Fordham University)

Abstract

This paper presents a model on contagion in nancial markets. We use a bank run framework as a mechanism to initiate a crisis and argues that liquidity crunch and imperfect information are the key culprits for a crisis to be contagious. The model proposes that a crisis is more likely to be contagious when (1) banks have similar cost-effciency structures (clustering) and (2) a large fraction of the investment is in the illiquid sector (illiquidity). The latter is an endogenous decision made by the banks. It increases with (1) the prospect of the risky asset (risk-return trade-off) and (2) the fraction of patient consumers (liquidity demand).

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Bibliographic Info

Paper provided by EconWPA in its series Finance with number 0207009.

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Date of creation: 30 Aug 2002
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Handle: RePEc:wpa:wuwpfi:0207009

Note: Type of Document - pdf; prepared on MikTex; to print on postscript; figures: included. produced via dvips
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Web page: http://128.118.178.162

Related research

Keywords: contagion; liquidity crunch; market crash; bank run; capital flight;

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References

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  1. repec:fth:coluec:602 is not listed on IDEAS
  2. H. Franklin Allen & Douglas Gale, . "Innovation in Financial Services, Relationships and Risk Sharing," Center for Financial Institutions Working Papers 97-26, Wharton School Center for Financial Institutions, University of Pennsylvania.
  3. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
  4. Green, Edward J. & Lin, Ping, 2003. "Implementing efficient allocations in a model of financial intermediation," Journal of Economic Theory, Elsevier, vol. 109(1), pages 1-23, March.
  5. Green, Edward J & Oh, Soo-Nam, 1991. "Contracts, Constraints and Consumption," Review of Economic Studies, Wiley Blackwell, vol. 58(5), pages 883-99, October.
  6. Davis, E. Philip, 1995. "Debt, Financial Fragility, and Systemic Risk," OUP Catalogue, Oxford University Press, number 9780198233312, September.
  7. Edward J. Green & Soo-Nam Oh, 1991. "Can a "credit crunch" be efficient?," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall, pages 3-17.
  8. Kristin Forbes & Roberto Rigobon, 1999. "No Contagion, Only Interdependence: Measuring Stock Market Co-movements," NBER Working Papers 7267, National Bureau of Economic Research, Inc.
  9. Caplin, A. & Leahy, J., 1992. "Business as Usual, Market Crashes and Wisdom After the Fact," Discussion Papers 1992_18, Columbia University, Department of Economics.
  10. Douglas W. Diamond, . "Liquidity, Banks and Markets," CRSP working papers 326, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  11. Roberto Rigobon, 1999. "On the Measurement of the International Propagation of Shocks," NBER Working Papers 7354, National Bureau of Economic Research, Inc.
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Citations

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Cited by:
  1. Haibin Zhu, 2001. "Bank runs without self-fulfilling prophecies," BIS Working Papers 106, Bank for International Settlements.
  2. Haibin Zhu, 2001. "Bank runs, welfare and policy implications," BIS Working Papers 107, Bank for International Settlements.
  3. Haibin Zhu, 2000. "Optimal Bank Runs without Self-Fulfilling Prophecies," Econometric Society World Congress 2000 Contributed Papers 1753, Econometric Society.

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