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Indirect contagion: the policy problem

Author

Listed:
  • Laurent Clerc
  • Alberto Giovannini
  • Sam Langfield
  • Tuomas Peltonen
  • Richard Portes
  • Martin Scheicher

Abstract

An epidemiologist calculating the risk of a localised epidemic becoming a global pandemic would investigate every possible channel of contagion from the infected region to the rest of the world. Focusing on, say, the incidence of close human contact would underestimate the pandemic risk if the disease could also spread through the air. Likewise, calculating the quantity of financial system risk requires practitioners to understand all of the channels through which small and local shocks can become big and global. Much of the empirical finance literature has focused only on “direct” contagion arising from firms’ contractual obligations. Direct contagion occurs if one firm’s default on its contractual obligations triggers distress (such as illiquidity or insolvency) at a counterparty firm. But contractual obligations are not the only means by which financial distress can spread, just as close human contact is not the only way that many infectious diseases are transmitted. Focusing only on direct contagion underestimates the risk of financial crisis given that other important channels exist. This paper represents an attempt to move systemic risk analysis closer to the holism of epidemiology. In doing so, we begin by identifying the fundamental channels of indirect contagion, which manifest even in the absence of direct contractual links. The first is the market price channel, in which scarce funding liquidity and low market liquidity reinforce each other, generating a vicious spiral. The second is information spillovers, in which bad news can adversely affect a broad range of financial firms and markets. Indirect contagion spreads market failure through these two channels. In the case of illiquidity spirals, firms do not internalise the negative externality of holding low levels of funding liquidity or of fire-selling assets into a thin market. Lack of information and information asymmetries can cause markets to unravel, even following a relatively small piece of bad news. In both cases, market players act in ways that are privately optimal but socially harmful. The spreading of market failure by indirect contagion motivates policy intervention. Substantial progress has been made in legislating for policies that will improve systemic resilience to indirect contagion. But more tools might be needed to achieve a fully effective and efficient macroprudential policy framework. This paper aims to frame a high-level policy discussion on three policy tools that could be effective and efficient in ensuring systemic resilience to indirect contagion – namely macroprudential liquidity regulation; restrictions on margins and haircuts; and information disclosure. JEL Classification: G15, G18

Suggested Citation

  • Laurent Clerc & Alberto Giovannini & Sam Langfield & Tuomas Peltonen & Richard Portes & Martin Scheicher, 2016. "Indirect contagion: the policy problem," ESRB Occasional Paper Series 09, European Systemic Risk Board.
  • Handle: RePEc:srk:srkops:201609
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    As found on the RePEc Biblio, the curated bibliography for Economics:
    1. > Economics of Welfare > Health Economics > Economics of Pandemics > Policy responses

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    2. Suarez, Javier & Sánchez Serrano, Antonio, 2018. "Approaching non-performing loans from a macroprudential angle," Report of the Advisory Scientific Committee 7, European Systemic Risk Board.
    3. Gerardo Ferrara & Sam Langfield & Zijun Liu & Tomohiro Ota, 2019. "Systemic illiquidity in the interbank network," Quantitative Finance, Taylor & Francis Journals, vol. 19(11), pages 1779-1795, November.
    4. Tente, Natalia & von Westernhagen, Natalja & Slopek, Ulf, 2017. "M-PRESS-CreditRisk: A holistic micro- and macroprudential approach to capital requirements," Discussion Papers 15/2017, Deutsche Bundesbank.
    5. Paula Marina Sarno & Norberto Montani Martins, 2018. "Derivatives, financial fragility and systemic risk: lessons from Barings Bank, Long-Term Capital Management, Lehman Brothers and AIG," Working Papers PKWP1812, Post Keynesian Economics Society (PKES).
    6. Aldasoro, Iñaki & Hüser, Anne-Caroline & Kok, Christoffer, 2020. "Contagion accounting," Bank of England working papers 897, Bank of England.
    7. Gabriele Visentin & Stefano Battiston & Marco D'Errico, 2016. "Rethinking Financial Contagion," Papers 1608.07831, arXiv.org.
    8. Abad, Jorge & D'Errico, Marco & Killeen, Neill & Luz, Vera & Peltonen, Tuomas & Portes, Richard & Urbano, Teresa, 2017. "Mapping the interconnectedness between EU banks and shadow banking entities," CEPR Discussion Papers 11919, C.E.P.R. Discussion Papers.
    9. Roncoroni, Alan & Battiston, Stefano & D'Errico, Marco & Hałaj, Grzegorz & Kok, Christoffer, 2019. "Interconnected banks and systemically important exposures," Working Paper Series 2331, European Central Bank.
    10. Calimani, Susanna & Hałaj, Grzegorz & Żochowski, Dawid, 2020. "Simulating fire sales in a system of banks and asset managers," Working Paper Series 2373, European Central Bank.
    11. Braouezec, Yann & Wagalath, Lakshithe, 2019. "Strategic fire-sales and price-mediated contagion in the banking system," European Journal of Operational Research, Elsevier, vol. 274(3), pages 1180-1197.

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    More about this item

    Keywords

    contagion; systemic risk; financial distress; liquidity shortages;
    All these keywords.

    JEL classification:

    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation

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