Financial Contagion through Capital Connections: A Model of the Origin and Spread of Bank Panics

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.

An Agent-Based Computational Model for Bank Formation and Interbank Networks

“…The Allen and Gale model (which will be denoted by AG) considered shocks as an excess liquidity demand faced by single banks based on the Diamond and Dybvig model [DD00] (denoted by DD) and used the mechanism of direct interbank linkages as the source of contagion in the financial system. Similar models are found in Temzelides [Tem97], Dasgupta [Das04], and Romero [Rom09], except that the propagation of the shocks is mainly carried out by agents in the system rather than by direct transfer through interbank links. For example, [Rom09] considers a social network of agents, where the agent decides on early withdrawing by asking three of his eight neighbours if they have already withdrawn.…”

Interbank Contagion in the Dutch Banking Sector

“…However, such a structure might also spread shocks more easily through the system, as shocks will not remain isolated at one bank or at a cluster of banks. In a model based on that of Diamond and Dybvig (1983), Dasgupta (2004) investigates the effect of a signal about a bank's health on customers' expectations and shows that contagion mainly runs from debtor banks to creditor banks.…”

Understanding Bank-Run Contagion

“…4,5 1 Allen et al (2011, chapter 3) identify five sources for systemic risk: common exposure to asset price bubbles; mispricing of assets; fiscal deficits and sovereign default; currency mismatches in the banking system; maturity mismatches and liquidity provision. A growing literature examines a wide range of channels through which contagion in the banking sector may occur, such as common asset exposure (Acharya, 2009;Ibragimov et al, 2011;Wagner, 2010), domino effects through the payments system or interbank markets due to counterparty risk (Allen and Gale, 2000;Dasgupta, 2004;Freixas and Parigi, 1998;Freixas et al, 2000;Rochet and Tirole, 1996), or price declines and resulting margin requirements (Brunnermeier and Pedersen, 2009). Beyond these recent events, the contagion of deposit withdrawals across banks has been documented for the U.S. during the Great Depression (Calomiris and Mason, 1997;Saunders and Wilson, 1996) as well as more recently in emerging markets (De Graeve and Karas, 2010;Iyer and Puri, 2012). However, the existing literature provides only scarce guidance on which underlying economic and informational conditions may foster contagious bank runs.…”