Contagion in Financial Markets

David Backus, Silverio Foresi and Liuren Wu
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Silverio Foresi: Goldman Sachs

Finance from University Library of Munich, Germany

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).

Keywords: contagion; liquidity crunch; market crash; bank run; capital flight (search for similar items in EconPapers)
JEL-codes: G10 G21 (search for similar items in EconPapers)
Date: 2002-08-30
Note: Type of Document - pdf; prepared on MikTex; to print on postscript; figures: included. produced via dvips
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Citations: View citations in EconPapers (3)

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Persistent link: https://EconPapers.repec.org/RePEc:wpa:wuwpfi:0207009

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