The Oxford Handbook of Banking by Allen N. Berger Philip Molyneux & John O.S. Wilson

Author:Allen N. Berger, Philip Molyneux & John O.S. Wilson
Language: eng
Format: epub
Publisher: Oxford University Press
Published: 2014-02-08T16:00:00+00:00

20.3.2 The Illiquidity View of Contagion

The simplest way to think about fire sales and illiquidity as triggering a systemic banking crisis is to assume the aggregate amount of liquidity in the market is fixed. This “cash in the market” extreme simplifying assumption, initially proposed by Allen and Gale (1994), has the benefit of providing the bare bones of the argument. When banks are confronted with a liquidity shock they will be forced to sell their assets independently of the market prices. With a given amount of cash in the market any increase in the sales is matched by a decrease in price. Consequently, if the number of defaulting banks is sufficiently large, this inevitably leads to some or all banks going bankrupt. Acharya and Yorulmazer (2007) consider a more sophisticated version of this approach and show the necessity of a LOLR intervention.

A more elaborated alternative to domino models of financial contagion is offered by Brunnermeier (2009) and Brunnermeier and Pedersen (2009) who argue that liquidity spirals may cause aggregate liquidity to dry up as a result of minor shocks. If leveraged informed investors suffer even minor losses on their assets, in order to maintain the same leverage they have to sell assets hence contributing to depress asset prices even further if market liquidity for the asset is low. In addition to this loss spiral, Brunnermeier and Pedersen (2009) identify a margin spiral arising from the fact that, typically, financial assets are purchased on credit (funding liquidity) using the purchased assets as collateral (margin) for the loan, often a short-term one. The margin spiral reinforces the loss spiral as investors suffering losses have to sell assets to meet higher margin demands, that is, to lower the leverage ratio. Adrian and Shin (2008) confirm this spiral empirically for the five major US investment banks in the period 1997–2007. They identify a strong positive relationship for investment banks between the value-weighted change in leverage and the change in assets hence showing that leverage is highly procyclical. This helps explain, according to Adrian and Shin (2008), how modest losses on US subprime mortgages triggered the most severe financial crisis since the Great Depression.

Finally, and more tentatively, the cross-banks link could also be underestimated if we restrict the analysis to solvency. In fact, a bank lending overnight to a peer financial institution that happens to be in default may not be fully satisfied with the knowledge that it will recover 95% of its claims in five years’ time, after the liquidation of the failing institution is complete. This may trigger the lending bank to liquidate some of its assets later at “fire sale,” possibly increasing the impact on the price of assets. Recently the possibility of contagion from the asset side of interlinked balance sheets has received explicit attention in the literature. Schnabel and Shin (2004) and Cifuentes, Shin, and Ferrucci (2005) show that changes in asset prices may interact with solvency requirements or with internal risk control and amplify the initial shock in a

Download

Copyright Disclaimer:
This site does not store any files on its server. We only index and link to content provided by other sites. Please contact the content providers to delete copyright contents if any and email us, we'll remove relevant links or contents immediately.