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Financial contagion through capital connections: a model of the origin and spread of bank panics

Dasgupta, Amil (2002) Financial contagion through capital connections: a model of the origin and spread of bank panics. Discussion paper, 436. Financial Markets Group, London School of Economics and Political Science, London, UK.

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Identification Number: 436

Abstract

Financial contagion is modeled as an equilibrium phenomenon in a dynamic setting with incomplete information and multiple banks. The equilibrium probability of bank failure is uniquely determined. We explore how the cross holding of deposits motivated by imperfectly correlated regional liquidity shocks can lead to contagious effects conditional on the failure of a financial institution. We show that contagion is possible in the unique equilibrium of the economy and characterize exactly when it may exist. At the same time, we identify a direction of flow for contagious effects, which provides a rationale for localized financial panics. Simulations identify the optimal level of interbank deposit holdings in the presence of contagion risk. Our results suggest that when the probability of bank failure is low, maximal levels of interbank holdings are optimal. When cross holding of deposits is complete, we demonstrate that the intensity of contagion is increasing in the size of regionally aggregate liquidity shocks.

Item Type: Monograph (Discussion Paper)
Official URL: http://fmg.lse.ac.uk
Additional Information: © 2002 The Author
Subjects: H Social Sciences > HG Finance
H Social Sciences > HB Economic Theory
JEL classification: C - Mathematical and Quantitative Methods > C7 - Game Theory and Bargaining Theory
G - Financial Economics > G2 - Financial Institutions and Services
Sets: Research centres and groups > Financial Markets Group (FMG)
Collections > Economists Online
Collections > LSE Financial Markets Group (FMG) Working Papers
Date Deposited: 20 Aug 2009 16:34
Last Modified: 27 Feb 2014 15:36
URI: http://eprints.lse.ac.uk/id/eprint/24956

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