Equilibrium Models

The prevalence of financial crises suggests that the financial sector is very sensitive to economic shocks in the sense that shocks which initially only affect a particular region can spread by contagion to the whole financial sector. One approach to model the propagation of contagion has been introduced in [6]. The authors concentrate on a single channel of financial contagion, namely the region-overlapping claims of an interbank deposit market, and model financial contagion as an equilibrium phenomenon. They focus mainly on the overlapping claims that different regions or sectors of the banking system have on one another. These interregional claims provide an insurance against liquidity preference shocks. The drawback, however, is that a small liquidity preference shock or even a bank crisis can spread from one region to the other regions which then might suffer a loss because their claims on the troubled region fall in value. If this spill-over effect is strong enough, the initially small shock in one region can cause a crisis in the adjacent regions and in extreme cases, the crisis can even pass from region to region and become contagious. [6] provide a micro-economically founded model of a banking system and consumers with uncertain liquidity preferences. Their analysis includes a first-best allocation and its decentralization. In their central result they provide sufficient conditions for an economic-wide crisis in a perturbed model. Furthermore they analyze, by illustrating different patterns of cross holdings, how completeness and connectedness of the interbank market structure can channel or attenuate contagion. A general problem with this approach, however, is that the additional uncertainty arising from the interaction of firms can easily be eliminated by means of diversification. This contradicts in some sense the idea of contagion since the risk, resulting from interactions between firms, is intrinsic and, thus, actually cannot be diversified away.