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Contagion in Financial Markets

Author

Listed:
  • 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).

Suggested Citation

  • David Backus & Silverio Foresi & Liuren Wu, 2002. "Contagion in Financial Markets," Finance 0207009, EconWPA.
  • 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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    File URL: http://econwpa.repec.org/eps/fin/papers/0207/0207009.pdf
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    References listed on IDEAS

    as
    1. 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.
    2. Diamond, Douglas W, 1997. "Liquidity, Banks, and Markets," Journal of Political Economy, University of Chicago Press, vol. 105(5), pages 928-956, October.
    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. Franklin Allen & Douglas Gale, 1999. "Innovations in Financial Services, Relationships, and Risk Sharing," Management Science, INFORMS, vol. 45(9), pages 1239-1253, September.
    5. 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 548-565, June.
    6. Roberto Rigobon, 1999. "On the Measurement of the International Propagation of Shocks," NBER Working Papers 7354, National Bureau of Economic Research, Inc.
    7. Kristin J. Forbes & Roberto Rigobon, 2002. "No Contagion, Only Interdependence: Measuring Stock Market Comovements," Journal of Finance, American Finance Association, vol. 57(5), pages 2223-2261, October.
    8. Edward J. Green & Soo-Nam Oh, 1991. "Contracts, Constraints and Consumption," Review of Economic Studies, Oxford University Press, vol. 58(5), pages 883-899.
    9. Davis, E. Philip, 1995. "Debt, Financial Fragility, and Systemic Risk," OUP Catalogue, Oxford University Press, number 9780198233312.
    10. 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.
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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, 2000. "Optimal Bank Runs without Self-Fulfilling Prophecies," Econometric Society World Congress 2000 Contributed Papers 1753, Econometric Society.
    3. Haibin Zhu, 2001. "Bank runs, welfare and policy implications," BIS Working Papers 107, Bank for International Settlements.

    More about this item

    Keywords

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

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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