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Contagion in Financial Markets

  • David Backus

    (New York University)

  • Silverio Foresi

    (Goldman Sachs)

  • Liuren Wu

    (Fordham University)

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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File URL: http://128.118.178.162/eps/fin/papers/0207/0207009.pdf
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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
Contact details of provider: Web page: http://128.118.178.162

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  1. Kristin Forbes & Roberto Rigobon, 1999. "No Contagion, Only Interdependence: Measuring Stock Market Co-movements," NBER Working Papers 7267, National Bureau of Economic Research, Inc.
  2. Douglas W. Diamond, . "Liquidity, Banks and Markets," CRSP working papers 326, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  3. Edward J. Green, 1995. "Implementing Efficient Allocations in a Model of Financial Intermediation," Meeting papers 9506001, EconWPA.
  4. Caplin, Andrew & Leahy, John, 1994. "Business as Usual, Market Crashes, and Wisdom after the Fact," American Economic Review, American Economic Association, vol. 84(3), pages 548-65, June.
  5. Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, vol. 91(3), pages 401-19, June.
  6. 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.
  7. Franklin Allen & Douglas Gale, 1999. "Innovations in Financial Services, Relationships, and Risk Sharing," Management Science, INFORMS, vol. 45(9), pages 1239-1253, September.
  8. Roberto Rigobon, 1999. "On the Measurement of the International Propagation of Shocks," NBER Working Papers 7354, National Bureau of Economic Research, Inc.
  9. Edward J. Green & Soo-Nam Oh, 1991. "Contracts, constraints, and consumption," Staff Report 143, Federal Reserve Bank of Minneapolis.
  10. Davis, E. Philip, 1995. "Debt, Financial Fragility, and Systemic Risk," OUP Catalogue, Oxford University Press, number 9780198233312.
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