Financial contagion

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Subprime Crisis Diagram

Financial contagion refers to a scenario in which small shocks, which initially affect only a few financial institutions or a particular region of an economy, spread to the rest of financial sectors and other countries whose economies were previously healthy, in a manner similar to the transmission of a medical disease. Financial contagion happens at both the international level and the domestic level.

At the domestic level, usually the failure of a domestic bank or financial intermediary triggers transmission when it defaults on interbank liabilities and sells assets in a fire sale, thereby undermining confidence in similar banks. An example of this phenomenon is the failure of Lehman Brothers and the subsequent turmoil in the United States financial markets.[1]

International financial contagion, which happens in both advanced economies and developing economies, is the transmission of financial crisis across financial markets for direct or indirect economies. However, under today's financial system, with large volume of cash flow, such as hedge fund and cross-regional operation of large banks, financial contagion usually happens simultaneously both among domestic institutions and across countries. The cause of financial contagion usually is beyond the explanation of real economy, such as the bilateral trade volume.[2]

History[edit]

While there was a period of systemic crisis in emerging countries in the early 1980s, both academia and policy circles did not analyze the crisis from a systematic point of view. Even when Latin American countries fell like dominoes into an abyss of successive devaluations, banking crises and deep recessions, much of the blame was placed on poor domestic policies and high real interest rates in the United States, with little attention focusing on the possibility that financial crises could be spreading and contagious.[3]

A Lexis-Nexis search for contagion before 1997 finds hundreds of examples in major newspapers, almost none of which refer to turmoil in international financial markets. The term “contagion” was first introduced in July 1997, when the currency crisis in Thailand quickly spread throughout East Asia and then on to Russia and Brazil. Even developed markets in North America and Europe were affected, as the relative prices of financial instruments shifted and caused the collapse of Long-Term Capital Management (LTCM), a large U.S. hedge fund. The financial crisis beginning from Thailand with the collapse of the Thai baht spread to Indonesia, the Philippines, Malaysia, South Korea and Hong Kong in less than 2 months.[4] After that, economists realized the importance of financial contagion and produced a large volume of researches on it.

Explanations[edit]

There are several branches of literatures explaining the mechanism of financial contagion.

One branch of them emphasizes contagious currency crises, relating such crises to various monetary and financial sector vulnerabilities and trade factors. These studies often look for the underlying causes behind a simultaneous set of speculative attacks.[5] For instance, Goldfajn and valdés (1997)[6] find that the intermediaries' role of transforming maturities is shown to result in larger movements of capital and a higher probability of crisis, which resemble the observed cycle in capital flows: large inflows, crisis and abrupt outflows. Kaminsky and Reinhart (2000)[7] document the evidence that trade links in goods and services and exposure to a common creditor can explain earlier crises clusters, not only the debt crisis of the early 1980s and 1990s, but also the observed historical pattern of contagion.

The second branch of literatures explain contagion transmission as a result of linkages among financial institutions. Alen and Gale (2000),[8] and Lagunoff and Schreft (2001)[9] analyze financial contagion as a result of linkages among financial intermediaries. The former provide a general equilibrium model to explain a small liquidity preference shock in one region can spread by contagion throughout the economy and the possibility of contagion depends strongly on the completeness of the structure of interregional claims. The latter proposed a dynamic stochastic game-theoretic model of financial fragility, through which they explain interrelated portfolios and payment commitments forge financial linkages among agents and thus make two related types of financial crisis can occur in response.

In addition, Van Rijckeghem and Weder (2000),[10] presents evidence that spillovers through bank lending contributed to the transmission of currency crises during the recent episodes of financial instability in emerging markets. Besides, in an era of rapid financial globalisation, Gai and Kapadia (2010),[11] prove that while high connectivity may increase the spread of financial contagion and adverse aggregate shocks and liquidity risk also amplify the likelihood and extent of financial contagion.

The third branch emphasize financial contagion among financial markets. This stream of researches try to explain contagion through a correlated information or a correlated liquidity shock channel. Under the correlated information channel, price changes in one market are perceived as having implications for the values of assets in other markets, causing their prices to change as well (King and Wadhwani (1990)).[12] Also,Calvo (1999) [13] argues for correlated liquidity shock channel meaning that when some market participants need to liquidate and withdraw some of their assets to obtain cash, perhaps after experiencing an unexpected loss in another country and need to restore capital adequacy ratios. This behavior will effectively transmit the shock.

In addition, there are some less-developed explanations for financial contagion. Some explanations for financial contagion, especially after the Russian default in 1998, are based on changes in investor “psychology”, “attitude” and “behavior”. This stream of research date back to early studies of crowd psychology of Mackay (1841)[14] and classical early models of disease diffusion were applied to financial markets by Shiller (1984).[15] Also, Kirman (1993)[16] analyses a simple model of influence that is motivated by the foraging behaviour of ants, but applicable, he argues, to the behaviour of stock market investors. Faced with a choice between two identical piles of food, ants switch periodically from one pile to the other. Kirman supposes that there are N ants and that each switches randomly between piles with probability ε (this prevents the system getting stuck with all at one pile or the other), and imitates a randomly chosen other ant with probability δ.[17] Eichengreen, Hale and Mody (2008)[18] focus on the transmission of recent crises through the market for developing country debt. They find the impact of changes in market sentiment tends to be limited to the original region. They also find market sentiments can more influence prices but less on quantities in Latin America, compared with Asian countries.

Besides, there are some researches on geographic factors driving the contagion. De Gregorio and Valdes (2001) examine how the 1982 debt crisis, the 1994 Mexican crisis, and the 1997 Asian crisis spread to a sample of twenty other countries.[19] They find that a neighborhood effect is the strongest determinant of which countries suffer from contagion. Trade links and pre-crisis growth similarities are also important, although to a lesser extent than the neighborhood effect.

A Simple Empirical Model[edit]

The empirical literature on testing for contagion has focused on increases in the correlation of returns between markets during periods of crisis. Forbes and Rigobon (2002)[20] begin by discussing the current imprecision and disagreement surrounding the term contagion. It proposes a concrete definition, a significant increase in cross-market linkages after a shock, and suggests using the term “interdependence” in order to differentiate this explicit definition from the existing literature. It shows the elementary weakness of simple correlation tests: with an unchanged regression coefficient, a rise in the variance of the explanatory variable reduces the coefficient standard error, causing a rise in the correlation of a regression. The regression underlying contagion tests is as follows:

Xt=θ(L)Xt+Θ(L)Itt (1)
Xt={xtc,xtj}      (2)
It={itc, itUS, itj}   (3)

where t is the time period for all variables; xc is the stock market return in the crisis country;, xj is the stock market return in another market j; Xt is a transposed vector of returns in the same two stock markets; Θ(L) and θ(L) are vectors of lags; ic, ius, and ij are short-term interest rates for the crisis country, the United States, and country j, respectively; and ξt is a vector of reduced-form disturbances. For each series of tests, they first use the VAR (vector autoregression) model in equations (1) through (3) to estimate the variance-covariance matrices for each pair of countries during the stable period, turmoil period, and full period. Then they use the estimated variance-covariance matrices to calculate the cross-market correlation coefficients (and their asymptotic distributions) for each set of markets and periods.

As Pesaran and Pick (2007)[21] observe, however, financial contagion is a difficult system to estimate econometrically. To disentangle contagion from interaction effects, county-specific variables have to be used to instrument foreign returns. Choosing the crisis period introduces sample selection bias, and it has to be assumed that crisis periods are sufficiently long to allow correlations to be reliably estimated. In consequence, there appears to be no strong consensus in the empirical literature as to whether contagion occurs between markets, or how strong it is.

Controversy[edit]

Some argue that strong linkages between countries are not necessarily contagion, and that contagion should be defined as an increase in cross-market linkages after a shock to one country, which is very hard to figure out by both theoretical model and empirical work. Also, some scholars argue that there is actually no contagion at all, just a high level of market comovement in all periods, which is market "interdependence."[20]

More generally, there is controversy surrounding the usefulness of "contagion" as a metaphor to describe the "catchiness" of social phenomena, as well as debate about the application of context-specific models and concepts from biomedicine and epidemiology to explain the diffusion of perturbations within financial systems.[22]

Policy Implications[edit]

Financial contagion is one of the main causes of financial regulation. How to make domestic financial regulation and plan the international financial architecture to prevent financial contagion become the top priority for both domestic financial regulators and international society, say, G-20 summit, especially when the global economy are being under challenge from the US Subprime mortgage crisis and European sovereign debt crisis.

At international level, under today's modern financial systems, a complicated web of claims and obligations link the balance sheets of a wide variety of intermediaries, such as hedge funds and banks, into a global financial network. The development of sophisticated financial products, such as credit default swaps and collateralized debt obligations, has complicated the financial regulation. As has been shown by the US financial recession, the trigger of failure of Lehman Brothers dramatically spread the shock to whole financial system and other financial markets. Therefore, understanding the reasons and mechanisms of international financial contagion can help policy makers improve the global financial regulation system and thus make it more resistant to shocks and contagions.

At domestic level, financial fragility is always associated with a short maturity of outstanding debt as well as contingent public liabilities. Therefore, a better domestic financial regulation structure can improve an economy’s liquidity and limit its exposure to contagion. A better understanding of financial contagion between financial intermediaries, including banking, rating agencies and hedge fund will be conducive to making financial reform in both US and European Countries, say how to set up the capital ratio to jungle the balance between maximizing banks' profit and shielding them from shocks and contagions.

See also[edit]

References[edit]

  1. ^ Scott, Hal S. (November 20, 2012). "Interconnectedness and Contagion". doi:10.2139/ssrn.2178475. SSRN 2178475. 
  2. ^ Robert Kollmann & Frédéric Malherbe, 2011. "International Financial Contagion: the Role of Banks, "Working Papers ECARES 2011-001, Universite Libre de Bruxelles.
  3. ^ Kaminsky, Graciela L., and Carmen M. Reinhart, 2000, On crises, contagion, and confusion, Journal of International Economics 51, 145-168.
  4. ^ Claessens, Stijn and Kristin Forbes, 2009, International Financial Contagion: An overview of the Issues, Springer.
  5. ^ Laura E. Kodres and Matthew Pritsker. A rational expectations model of financial contagion. The Journal of Finance, 57(2):pp. 769–799, 2002.
  6. ^ Goldfajn, Ilan, and Rodrigo Valdés, 1997, Capital flows and the twin crises: The role of liquidity, IMF Working Paper No. 97/87, International Monetary Fund, Washington, DC.
  7. ^ Kaminsky, Graciela L., and Carmen M. Reinhart, 2000, On crises, contagion, and confusion, Journal of International Economics 51, 145-168.
  8. ^ Allen, Franklin and Douglas Gale, 2000, Journal of Political Economy, Vol. 108, No.1, pp.1-11.
  9. ^ Lagunoff, Roger D., and Stacey L. Schreft, 2001, A model of financial fragility, Journal of Economic Theory 99, 220-264.
  10. ^ Van Rijckeghem, Caroline, and Beatrice Weder, 2003, Spillovers through banking centers: A panel data analysis, Journal of International Money and Finance, 483–509.
  11. ^ Contagion in Financial Networks, March 2010, Bank of England working paper No. 383.
  12. ^ King, Mervyn A., and Sushil Wadhwani, 1990, Transmission of volatility between stock markets, Review of Financial Studies 3, 5-33.
  13. ^ Calvo, Guillermo A., 1999, Contagion in emerging markets: When Wall Street is a carrier, Working paper, University of Maryland.
  14. ^ Mackay, C. 1841. Extraordinary Popular Delusions and the Madness of Crowds. London: Bentley.
  15. ^ Shiller, R.J. 1984. Stock prices and social dynamics. Brookings Papers on Economic Activity 1984(2), 457–98.
  16. ^ Kirman, A. 1993. Ants, rationality, and recruitment. Quarterly Journal of Economics 108, 137–56.
  17. ^ Kelly, Morgan (2008-02). "The New Palgrave Dictionary of Economics".
  18. ^ Eichengreen, Hale and Mody, 2006, “Flight to Quality: Investor Risk Tolerance and the Spread of Emerging Market Crises”, in International Financial Contagion: An overview of the Issues and the Book by Claessens, Stijn and Kristin Forbes.
  19. ^ De Gregorio, José; Valdes, Rodrigo O. (2001). "Crisis Transmission: Evidence from the Debt, Tequila, and Asian Flu Crises". World Bank Econ Rev 15 (2): 289–314. doi:10.1093/wber/15.2.289. 
  20. ^ a b Kristin J. Forbes and Roberto Rigobon, 2002, No Contagion, Only Interdependence: Measuring Stock Market Comovements, The Journal of Finance, Vol. 57, No. 5, pp 2223-2261.
  21. ^ Pesaran, M.H. and Pick, A. 2007. Econometric issues in the analysis of contagion. Journal of Economic Dynamics and Control 31, 1245–77.
  22. ^ Peckham, Robert (2013). "Economies of Contagion: Financial Crisis and Pandemic". Economy and Society 42 (2): 226–248. doi:10.1080/03085147.2012.718626.