Financial Market Contagion May Be Rare, But It Can Be Deadly
From the “Now They Tell Us” Department. A new Working Paper from the Bank of England finds that while contagion in financial markets is rare, the effects can be severe when problems do arise.
Selected excerpts:
Our results suggest that financial systems may exhibit a robust-yet-fragile tendency: while the probability of contagion may be low, the effects can be extremely widespread when problems occur. The model also highlights how seemingly indistinguishable shocks can have very different consequences for the financial system depending on whether or not the shock hits at a particular pressure point in the network structure.
This helps explain why the evidence of the resilience of the system to fairly large shocks prior to 2007 was not a reliable guide to its future robustness.
In a highly connected system, the counterparty losses of a failing institution can be more widely dispersed to, and absorbed by, other entities. So increased connectivity and risk sharing may lower the probability of contagious default. But, conditional on the failure of one institution triggering contagious defaults, a high number of financial linkages also increases the potential for contagion to spread more widely.
In particular, high connectivity increases the chances that institutions which survive the effects of the initial default will be exposed to more than one defaulting counterparty after the first round of contagion, thus making them vulnerable to a second-round default. The effects of any crises that do occur can, therefore, be extremely widespread.
- From The Bank of England Working Paper Contagion in financial networks by Prasanna Gai and Sujit Kapadia
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