Disciplines
Finance and Financial Management
Abstract
This paper presents a model on contagion in financial markets. We use a bank run framwork 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).
Recommended Citation
Backus, David; Foresi, Silverio; and Wu, Liuren, "Liquidity and Contagion in Financial Markets" (1999). CRIF Working Paper series. 31.
https://research.library.fordham.edu/crif_working_papers/31
