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Contagion of a Liquidity Crisis Between Two Firms

Author

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  • Frederick Dongchuhl Oh

    (Economic Reseach Institute, The Bank of Korea)

Abstract

This paper presents a model in which the contagion of a liquidity crisis between two nonfinancial institutions occurs because of learning activity within a common creditor pool. After creditors observe what occurs in a rollover game for a firm, they conjecture one another’s “type†or attitude toward the risk associated with the firm’s investment project. Creditors’ inference about one another’s type then influences their decision to lend to the next firm. By providing an analysis of the “incidence of failure†(the threshold for a liquidity crisis) for each firm, this paper demonstrates that the risk of contagion increases sharply if it originates ex ante from a firm facing a low probability of failure. In addition, the paper proposes some policy measures for mitigating the severity of contagion during a liquidity crisis.

Suggested Citation

  • Frederick Dongchuhl Oh, 2012. "Contagion of a Liquidity Crisis Between Two Firms," Working Papers 2012-3, Economic Research Institute, Bank of Korea.
    • Handle: RePEc:bok:wpaper:1203
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    File URL: http://www.bok.or.kr/attach/imer_kor/1229/2012/05/1338279366992.pdf
    File Function: Working Paper, 2012
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    Citations

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    Cited by:

    1. Goldstein, Itay & Razin, Assaf, 2015. "Three Branches of Theories of Financial Crises," Foundations and Trends(R) in Finance, now publishers, vol. 10(2), pages 113-180, 30.
    2. Franklin Allen, 2012. "Commentary: the ‘big C”: identifying and mitigating contagion," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 89-96.

    More about this item

    Keywords

    Contagion; Liquidity Crisis; Global Game; Learning; Coordination Failure; Collateral; Government Bailout; Information Structure; Financial Disclosure;
    All these keywords.

    JEL classification:

    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
    • G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness

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