Contagion of a Liquidity Crisis Between Two Firms

Frederick Dongchuhl Oh ()
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Frederick Dongchuhl Oh: Economic Reseach Institute, The Bank of Korea

No 2012-3, Working Papers from Economic Research Institute, 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.

Keywords: Contagion; Liquidity Crisis; Global Game; Learning; Coordination Failure; Collateral; Government Bailout; Information Structure; Financial Disclosure (search for similar items in EconPapers)
JEL-codes: D82 D83 G33 G38 (search for similar items in EconPapers)
Pages: 62 pages
Date: 2012-04-24
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Citations: View citations in EconPapers (2)

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