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CRIF Working Paper No. 02018 Contagion in Financial Markets
Title: Contagion in Financial Markets
Authors: David Backus (New York University) Silverio Foresi (Goldman Sachs Asset Management) Liuren Wu (Fordham University)
Contact: wu@fordham.edu
Keywords: Contagion, liquidity crunch, financial crises, bank runs, market crashes, business cycle, capital flight.
JEL Classification: G10, G21
Abstract: This paper presents a model on contagion in financial 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-efficiency 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).
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