Universität Mannheim / VWL / Priority Programme 1578 / Navigation / Projects / Financial Contagion through Market Prices - Theory and Evidence

Financial Contagion through Market Prices - Theory and Evidence

Coordinator: Prof. Dr. Hendrik Hakenes, Prof. Dr. Isabel Schnabel

Participants: Dipl.-Vw. Andreas Barth, Dipl.-Vw. Florian Hett

It has been argued that the severity of the recent financial crisis can be explained by macroeconomic feedback effects from the distress at individual financial institutions through market prices to the financial sector as a whole. If a bank suffers a liquidity shock, it may be forced to dispose of some of its assets to remain liquid. This may lead to a depression of asset prices, which affects other financial institutions holding the same assets. Other banks can now sell their assets only at lower prices, or may even be forced to adjust the valuation of these assets immediately if they mark their assets to market. These banks may be forced to carry out further asset sales if they are close to their regulatory capital requirements, reinforcing the original price effect. 
The goal of this project is to develop a theoretical framework of such feedback effects, and to design appropriate regulatory responses. Two important components of the model are the connection of banks through interbank liabilities, and price discounts when selling assets in response to a liquidity shock. The theoretical model will be used to derive specific hypotheses, which are to be tested in the second part of the project. The empirical analysis is going to be based on a detailed data set on the evolution of German banks’ own securities holdings during the recent financial crisis. We test not only for the existence of financial contagion through market prices, but we also quantify the magnitude of the contagion effect and analyze its determinants.

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