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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, University Library of Munich, Germany.
    • 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: https://econwpa.ub.uni-muenchen.de/econ-wp/fin/papers/0207/0207009.pdf
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    References listed on IDEAS

    as
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    3. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, vol. 24(Win), pages 14-23.
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    6. Waldo, Douglas G., 1985. "Bank runs, the deposit-currency ratio and the interest rate," Journal of Monetary Economics, Elsevier, vol. 15(3), pages 269-277, May.
    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. 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.
    9. Roberto Rigobon, 1999. "On the Measurement of the International Propagation of Shocks," NBER Working Papers 7354, National Bureau of Economic Research, Inc.
    10. 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.
    11. Davis, E. Philip, 1995. "Debt, Financial Fragility, and Systemic Risk," OUP Catalogue, Oxford University Press, number 9780198233312.
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    Citations

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    Cited by:

    1. Haibin Zhu, 2001. "Bank runs, welfare and policy implications," BIS Working Papers 107, Bank for International Settlements.
    2. Haibin Zhu, 2001. "Bank runs without self-fulfilling prophecies," BIS Working Papers 106, 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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    More about this item

    Keywords

    contagion; liquidity crunch; market crash; bank run; capital flight;
    All these keywords.

    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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