Term Paper
Content
Introduction:
The international banking system has expanded rapidly since the late-1990s. In addition to the
overall size of banking assets, the international positions of banks from many of the major
banking systems have grown significantly, by several multiples, during this period. Thus, the
banking sector, which continues to be of key importance for global financial stability, represents
a potentially important channel for contagion risk through the international financial system.
Financial contagion happens at both the international level and the domestic level. At the
domestic level, usually the failure of a domestic bank or financial intermediary triggers
transmission when it defaults on interbank liabilities and sells assets in a fire sale, thereby
undermining confidence in similar banks. An example of this phenomenon is the subsequent
turmoil in the United States financial markets. International financial contagion, which happens
in both advanced economies and developing economies, is the transmission of financial crisis
across financial markets for direct or indirect economies. However, under today’s financial
system, with large volume of cash flow, such as hedge fund and cross-regional operation of large
banks, financial contagion usually happens simultaneously both among domestic institutions and
across countries. The cause of financial contagion usually is beyond the explanation of real
economy, such as the bilateral trade volume.
The debate on the need for banking regulation and supervision depends critically on the question
whether there is contagion risk in banking, or not. Contagion risk—which is also referred to as
systemic risk—is here defined as the risk that financial difficulties at one or more bank(s) spill
over to a large number of other banks or the financial system as a whole. There has been little
attempting so far to measure contagion risk. Reviewing the limited empirical evidence of bank
contagion, Kaufman (1994) comes to the conclusion that concerns about systemic stability have
been greatly exaggerated.
Contagion risk in banking:
The phenomenon of bank runs has been rigorously modeled in the literature. A first set of models
(e.g. Diamond and Dybvig, 1983; Postlewaite and Vives, 1987) assumes consumption risk—
reflected in a stochastic withdrawal of deposits—and riskless, but illiquid, investments. The
illiquidity of these investments provides the rationale for the existence of banks and for their
vulnerability to runs. Exces-sive withdrawals of deposits would force a bank into costly
liquidation. Hence, if a depositor expects that others will withdraw, he will also withdraw to
avoid losses from such liquidation. The Diamond-Dybvig model gives rise to multiple equilibria,
including bank run equilibrium. A bank run is caused by a shift in expectations, which can
depend on some commonly observed factor such as a sunspot (it need not be anything
fundamental about the bank’s condition). In a more realistic setting, a second set of bank run
models (e.g. Chari and Jagannathan, 1988; Gorton, 1985) introduces investment risk in addition
to con-sumption risk. Asymmetric information between the bank and its depositors on the true
value of loans is a key element of these models. In the Chari-Jagannathan model, only a fraction
of depositors receives information on the prospects of loans. Uninformed depositors, however,
do not know whether large deposit withdrawals are caused by an increase in the fraction of early
consumers and/or by information on a low outcome of loans. Given that a long withdrawal queue
could be caused by bad information about a bank’s solvency, the rational response of the
uninformed depositor is to join the queue as well and withdraw early. An information-induced
bank run can thus occur, even if no one receives a bad signal. The Chari-Jagannathan and
Diamond-Dybvig models differ in that bank runs in the former start with fears of insolvency of
particular banks, while bank runs in the latter are based on self-fulfilling beliefs.
Different transmission channels of Contagion:
The contagion could be channeled through its linkages with other major banks or through its
operations in global financial centers. There are numerous specific ways in which this could
occur. Notably, external linkages could stem from direct and indirect equity exposures of local
banks to overseas banks or, conversely, shareholdings of local banks by foreign banks; direct
exposures through loan books; deposit and funding sources from overseas and/or from foreign
banks operating in a particular country; payments and settlement systems; holdings of credit risk
transfer instruments written on assets held by local and/or overseas institutions. Contagion could
also occur without any explicit links between banks when a negative shock in one bank is
misinterpreted by investors as a signal of diminished soundness in other banks, either in the same
country or in a different country.
The purpose of the paper:
This paper focuses on determining the channels of contagion risk among the world’s largest,
systemic banks, using the extreme value theory (EVT) framework.
It should be noted that the exact nature of the links between the financial institutions is not
explored in this paper. Rather, the results are intended to represent “maps” that could guide the
allocation of limited surveillance and supervisory resources, so that more detailed links may then
be identified as necessary. In addition to highlighting the relationships among the major global
banks, it could also focus cross-border collaboration among supervisors in these countries.
The aim is to identify potential risk concentrations among the world’s systemically important
banks. Arguably, even if a crisis cannot ultimately be averted, early detection of vulnerabilities in
the financial system could provide country authorities extra time to prepare contingency plans,
and focus attention on likely stress points. To this end, understanding the interdependencies
between individual banks with potential systemic impact and their exposure to economic and
financial risks is crucial.
Research Questions:
•
Are all banks similarly affected by common shocks to the global economy or financial
system?
•
Are banks predominantly influenced by domestic shocks, either because of their domestic
focus or the local regulatory environment, despite being largely integrated into the global
financial system?
•
Are different banks—irrespective of domicile—affected differently by shocks, due to
their increasingly different business and geographic mixes?
Research Findings:
•
Banks are also generally affected by common shocks to the real economy or financial
markets, although the global banking system as a whole tends to be more exposed to
these shocks during more turbulent periods, compared to the more benign periods.
•
“Home bias” is an important factor in terms of contagion risk.
•
Foreign banks’ idiosyncratic shocks.
Causes and Consequences:
Financial contagion can create financial volatility and can seriously damage the economy and
financial systems of countries. There are several branches of classifications that explain the
mechanism of financial contagion, which are spillover effects and financial crisis that are caused
by the influence of the four agents’ behavior. The four agents that influence financial
globalization are governments, financial institutions, investors, and borrowers.
The first branch, spill-over effects, can be seen as negative externalities. Spillover effects are also
known as fundamental-based contagion. These effects can happen either globally, heavily
affecting many countries in the world, or regionally, affecting only neighboring countries. The
big players, who are more of the larger countries, usually have a global effect. The smaller
countries are the players who usually have a regional effect. These forms of co-movements
would not normally constitute contagion, but if they occur during a period of crisis and their
effect is adverse, they may be expressed as contagion.
“Fundamental causes of contagion include macroeconomic shocks that have repercussions on an
international scale and local shocks transmitted through trade links, competitive devaluations,
and financial links.” It can lead to some co-movements in capital flows and asset prices.
Common shocks can be similar to the effects of financial links. “A financial crisis in one country
can lead to direct financial effects, including reductions in trade credits, foreign direct
investment, and other capital flows abroad” Financial links come from financial globalization
since countries try to be more economically integrated with global financial markets. Alen and
Gale (2000), and Lagunoff and Schreft (2001) analyze financial contagion as a result of linkages
among financial intermediaries. The former provide a general equilibrium model to explain a
small liquidity preference shock in one region can spread by contagion throughout the economy
and the possibility of contagion depends strongly on the completeness of the structure of
interregional claims. The latter proposed a dynamic stochastic game-theoretic model of financial
fragility, through which they explain interrelated portfolios and payment commitments forge
financial linkages among agents and thus make two related types of financial crisis can occur in
response.
Trade links is another type of shock that has its similarities to common shocks and financial
links. These types of shocks are more focused on its integration causing local impacts. “Any
major trading partner of a country in which a financial crisis has induced a sharp current
depreciation could experience declining asset prices and large capital outflows or could become
the target of a speculative attack as investors anticipate a decline in exports to the crisis country
and hence a deterioration in the trade account.” Kaminsky and Reinhart (2000) document the
evidence that trade links in goods and services and exposure to a common creditor can explain
earlier crises clusters, not only the debt crisis of the early 1980s and 1990s, but also the observed
historical pattern of contagion.
Competitive devaluation is also associated with financial contagion. Competitive devaluation,
which is also known as a currency war, is when multiple countries compete against one another
to gain a competitive advantage by having low exchange rates for their currency. “Devaluation in
a country hit by a crisis reduces the export competitiveness of the countries with which it
competes in third markets, putting pressure on the currencies of other countries; especially when
those currencies do not float freely.” This action causes countries to act irrationally due to fear
and doubt. “If market participants expect that a currency crisis will lead to a game of competitive
devaluation, they will naturally sell their holdings of securities of other countries, curtail their
lending, or refuse to roll over short-term loans to borrowers in those countries.”
Another branch of contagion is a financial crisis, which is also referred to irrational phenomena.
A financial crisis as a branch of contagion is formed when “a co-movement occurs, even when
there are no global shocks and interdependence and fundamentals are not factors.” It’s caused by
any of the four agents’ behaviors who influence financial globalization. Some examples that can
cause contagion are increased risk aversion, lack of confidence, and financial fears. Under the
correlated information channel, price changes in one market are perceived as having implications
for the values of assets in other markets, causing their prices to change as well (King and
Wadhwani (1990)). Also,Calvo (1999) argues for correlated liquidity shock channel meaning that
when some market participants need to liquidate and withdraw some of their assets to obtain
cash, perhaps after experiencing an unexpected loss in another country and need to restore
capital adequacy ratios. This behavior will effectively transmit the shock.
Out of the four agents, an investor’s behavior seems to be one of the biggest one that can impact
a country’s financial system. There are three different types of investor behaviors, which
generally are considered rational or irrational and individually or collectively.
Learning:
•
In the world’s biggest banking market, we find that U.S. banks are vulnerable to
contagion risk from banks from their own country as well as from overseas.
•
No European bank represents a consistently common contagion factor.
•
U.S. banks during this period have not necessarily been tied to developments in the local
market or economy. Rather, bank soundness appears to be more closely related to
volatilities in global markets, potentially reflecting the global nature of U.S. banking
businesses.
Suggestions:
•
Need to ensure sound risk management practices.
•
Need to improve cooperation in cross-border financial crisis prevention and management.
•
There is a need for further work on cross-border co-ordination and information sharing
between national authorities in promoting financial stability.
Conclusion:
The risk of contagion among local banks is important (“home bias”). Banks are also affected by
common shocks to the real economy or financial markets, although they tend to be more
vulnerable to these shocks during more turbulent periods, compared to the more benign times.
Meanwhile, contagion risk among the major global banks appears to have increased over time.
Nonetheless, country authorities largely acknowledge that there is a need for further work on
cross-border co-ordination and information sharing between national authorities in promoting
financial stability.
The international banking system has expanded rapidly since the late-1990s. In addition to the
overall size of banking assets, the international positions of banks from many of the major
banking systems have grown significantly, by several multiples, during this period. Thus, the
banking sector, which continues to be of key importance for global financial stability, represents
a potentially important channel for contagion risk through the international financial system.
Financial contagion happens at both the international level and the domestic level. At the
domestic level, usually the failure of a domestic bank or financial intermediary triggers
transmission when it defaults on interbank liabilities and sells assets in a fire sale, thereby
undermining confidence in similar banks. An example of this phenomenon is the subsequent
turmoil in the United States financial markets. International financial contagion, which happens
in both advanced economies and developing economies, is the transmission of financial crisis
across financial markets for direct or indirect economies. However, under today’s financial
system, with large volume of cash flow, such as hedge fund and cross-regional operation of large
banks, financial contagion usually happens simultaneously both among domestic institutions and
across countries. The cause of financial contagion usually is beyond the explanation of real
economy, such as the bilateral trade volume.
The debate on the need for banking regulation and supervision depends critically on the question
whether there is contagion risk in banking, or not. Contagion risk—which is also referred to as
systemic risk—is here defined as the risk that financial difficulties at one or more bank(s) spill
over to a large number of other banks or the financial system as a whole. There has been little
attempting so far to measure contagion risk. Reviewing the limited empirical evidence of bank
contagion, Kaufman (1994) comes to the conclusion that concerns about systemic stability have
been greatly exaggerated.
Contagion risk in banking:
The phenomenon of bank runs has been rigorously modeled in the literature. A first set of models
(e.g. Diamond and Dybvig, 1983; Postlewaite and Vives, 1987) assumes consumption risk—
reflected in a stochastic withdrawal of deposits—and riskless, but illiquid, investments. The
illiquidity of these investments provides the rationale for the existence of banks and for their
vulnerability to runs. Exces-sive withdrawals of deposits would force a bank into costly
liquidation. Hence, if a depositor expects that others will withdraw, he will also withdraw to
avoid losses from such liquidation. The Diamond-Dybvig model gives rise to multiple equilibria,
including bank run equilibrium. A bank run is caused by a shift in expectations, which can
depend on some commonly observed factor such as a sunspot (it need not be anything
fundamental about the bank’s condition). In a more realistic setting, a second set of bank run
models (e.g. Chari and Jagannathan, 1988; Gorton, 1985) introduces investment risk in addition
to con-sumption risk. Asymmetric information between the bank and its depositors on the true
value of loans is a key element of these models. In the Chari-Jagannathan model, only a fraction
of depositors receives information on the prospects of loans. Uninformed depositors, however,
do not know whether large deposit withdrawals are caused by an increase in the fraction of early
consumers and/or by information on a low outcome of loans. Given that a long withdrawal queue
could be caused by bad information about a bank’s solvency, the rational response of the
uninformed depositor is to join the queue as well and withdraw early. An information-induced
bank run can thus occur, even if no one receives a bad signal. The Chari-Jagannathan and
Diamond-Dybvig models differ in that bank runs in the former start with fears of insolvency of
particular banks, while bank runs in the latter are based on self-fulfilling beliefs.
Different transmission channels of Contagion:
The contagion could be channeled through its linkages with other major banks or through its
operations in global financial centers. There are numerous specific ways in which this could
occur. Notably, external linkages could stem from direct and indirect equity exposures of local
banks to overseas banks or, conversely, shareholdings of local banks by foreign banks; direct
exposures through loan books; deposit and funding sources from overseas and/or from foreign
banks operating in a particular country; payments and settlement systems; holdings of credit risk
transfer instruments written on assets held by local and/or overseas institutions. Contagion could
also occur without any explicit links between banks when a negative shock in one bank is
misinterpreted by investors as a signal of diminished soundness in other banks, either in the same
country or in a different country.
The purpose of the paper:
This paper focuses on determining the channels of contagion risk among the world’s largest,
systemic banks, using the extreme value theory (EVT) framework.
It should be noted that the exact nature of the links between the financial institutions is not
explored in this paper. Rather, the results are intended to represent “maps” that could guide the
allocation of limited surveillance and supervisory resources, so that more detailed links may then
be identified as necessary. In addition to highlighting the relationships among the major global
banks, it could also focus cross-border collaboration among supervisors in these countries.
The aim is to identify potential risk concentrations among the world’s systemically important
banks. Arguably, even if a crisis cannot ultimately be averted, early detection of vulnerabilities in
the financial system could provide country authorities extra time to prepare contingency plans,
and focus attention on likely stress points. To this end, understanding the interdependencies
between individual banks with potential systemic impact and their exposure to economic and
financial risks is crucial.
Research Questions:
•
Are all banks similarly affected by common shocks to the global economy or financial
system?
•
Are banks predominantly influenced by domestic shocks, either because of their domestic
focus or the local regulatory environment, despite being largely integrated into the global
financial system?
•
Are different banks—irrespective of domicile—affected differently by shocks, due to
their increasingly different business and geographic mixes?
Research Findings:
•
Banks are also generally affected by common shocks to the real economy or financial
markets, although the global banking system as a whole tends to be more exposed to
these shocks during more turbulent periods, compared to the more benign periods.
•
“Home bias” is an important factor in terms of contagion risk.
•
Foreign banks’ idiosyncratic shocks.
Causes and Consequences:
Financial contagion can create financial volatility and can seriously damage the economy and
financial systems of countries. There are several branches of classifications that explain the
mechanism of financial contagion, which are spillover effects and financial crisis that are caused
by the influence of the four agents’ behavior. The four agents that influence financial
globalization are governments, financial institutions, investors, and borrowers.
The first branch, spill-over effects, can be seen as negative externalities. Spillover effects are also
known as fundamental-based contagion. These effects can happen either globally, heavily
affecting many countries in the world, or regionally, affecting only neighboring countries. The
big players, who are more of the larger countries, usually have a global effect. The smaller
countries are the players who usually have a regional effect. These forms of co-movements
would not normally constitute contagion, but if they occur during a period of crisis and their
effect is adverse, they may be expressed as contagion.
“Fundamental causes of contagion include macroeconomic shocks that have repercussions on an
international scale and local shocks transmitted through trade links, competitive devaluations,
and financial links.” It can lead to some co-movements in capital flows and asset prices.
Common shocks can be similar to the effects of financial links. “A financial crisis in one country
can lead to direct financial effects, including reductions in trade credits, foreign direct
investment, and other capital flows abroad” Financial links come from financial globalization
since countries try to be more economically integrated with global financial markets. Alen and
Gale (2000), and Lagunoff and Schreft (2001) analyze financial contagion as a result of linkages
among financial intermediaries. The former provide a general equilibrium model to explain a
small liquidity preference shock in one region can spread by contagion throughout the economy
and the possibility of contagion depends strongly on the completeness of the structure of
interregional claims. The latter proposed a dynamic stochastic game-theoretic model of financial
fragility, through which they explain interrelated portfolios and payment commitments forge
financial linkages among agents and thus make two related types of financial crisis can occur in
response.
Trade links is another type of shock that has its similarities to common shocks and financial
links. These types of shocks are more focused on its integration causing local impacts. “Any
major trading partner of a country in which a financial crisis has induced a sharp current
depreciation could experience declining asset prices and large capital outflows or could become
the target of a speculative attack as investors anticipate a decline in exports to the crisis country
and hence a deterioration in the trade account.” Kaminsky and Reinhart (2000) document the
evidence that trade links in goods and services and exposure to a common creditor can explain
earlier crises clusters, not only the debt crisis of the early 1980s and 1990s, but also the observed
historical pattern of contagion.
Competitive devaluation is also associated with financial contagion. Competitive devaluation,
which is also known as a currency war, is when multiple countries compete against one another
to gain a competitive advantage by having low exchange rates for their currency. “Devaluation in
a country hit by a crisis reduces the export competitiveness of the countries with which it
competes in third markets, putting pressure on the currencies of other countries; especially when
those currencies do not float freely.” This action causes countries to act irrationally due to fear
and doubt. “If market participants expect that a currency crisis will lead to a game of competitive
devaluation, they will naturally sell their holdings of securities of other countries, curtail their
lending, or refuse to roll over short-term loans to borrowers in those countries.”
Another branch of contagion is a financial crisis, which is also referred to irrational phenomena.
A financial crisis as a branch of contagion is formed when “a co-movement occurs, even when
there are no global shocks and interdependence and fundamentals are not factors.” It’s caused by
any of the four agents’ behaviors who influence financial globalization. Some examples that can
cause contagion are increased risk aversion, lack of confidence, and financial fears. Under the
correlated information channel, price changes in one market are perceived as having implications
for the values of assets in other markets, causing their prices to change as well (King and
Wadhwani (1990)). Also,Calvo (1999) argues for correlated liquidity shock channel meaning that
when some market participants need to liquidate and withdraw some of their assets to obtain
cash, perhaps after experiencing an unexpected loss in another country and need to restore
capital adequacy ratios. This behavior will effectively transmit the shock.
Out of the four agents, an investor’s behavior seems to be one of the biggest one that can impact
a country’s financial system. There are three different types of investor behaviors, which
generally are considered rational or irrational and individually or collectively.
Learning:
•
In the world’s biggest banking market, we find that U.S. banks are vulnerable to
contagion risk from banks from their own country as well as from overseas.
•
No European bank represents a consistently common contagion factor.
•
U.S. banks during this period have not necessarily been tied to developments in the local
market or economy. Rather, bank soundness appears to be more closely related to
volatilities in global markets, potentially reflecting the global nature of U.S. banking
businesses.
Suggestions:
•
Need to ensure sound risk management practices.
•
Need to improve cooperation in cross-border financial crisis prevention and management.
•
There is a need for further work on cross-border co-ordination and information sharing
between national authorities in promoting financial stability.
Conclusion:
The risk of contagion among local banks is important (“home bias”). Banks are also affected by
common shocks to the real economy or financial markets, although they tend to be more
vulnerable to these shocks during more turbulent periods, compared to the more benign times.
Meanwhile, contagion risk among the major global banks appears to have increased over time.
Nonetheless, country authorities largely acknowledge that there is a need for further work on
cross-border co-ordination and information sharing between national authorities in promoting
financial stability.
