We develop a multiple asset rational expectations model of asset prices to explain financial market contagion. Although the model allows contagion through several channels, our focus is on contagion through cross-market rebalancing. Through this channel, investors transmit idiosyncratic shocks from one market to others by adjusting their portfolios ’ exposures to shared macroeconomic risks. The pattern and severity of financial contagion depends on markets ’ sensitivities to shared macroeconomic risk factors, and on the amount of information asymmetry in each market. The model can generate contagion in the absence of news, and between markets that do not directly share macroeconomic risks.

This paper summarizes and explains the main events of the liquidity and credit crunch in 2007-08. Starting with the trends leading up to the crisis, I explain how these events unfolded and how four different amplification mechanisms magnified losses in the mortgage market into large dislocations and turmoil in financial markets.

contagion captures the co-incidence of extreme return shocks across countries within a region the extent of contagion, its economic significance, and its determinants using a multinomial 1990s, we find that contagion, when measured by the co-incidence within and across regions of changes, and conditional stock return volatility. Evidence that contagion is stronger for extreme September 2001 Associate Professor, College of Business Administration, Korea University ** Professor of Finance and Dean's Distinguished Research Professor, Fisher College of Business, Ohio State University *** Professor of Finance and Reese Chair of Banking and Monetary Economics, Fisher College of Business, Ohio State University, Research Associate, National Bureau of Economic Research. The authors are grateful to the Dice Center for Research on Financial Economics for support. We thank Tom Santner, Mark Berliner, Bob Leone, and Stan Lemeshow for useful discussions on methodology, Steve Cecchetti, Peter Christoffersen, Craig Doidge, Barry Eichengreen, Vihang Errunza, David Hirshleifer, Roberto Rigobon, Richard Roll, Karen Wruck and, especially, an anonymous referee and the editor, Cam Harvey, for comments. Comments from seminar participants at Hong Kong University of Science and Technology, Korea University, McGill University, Yale University, Michigan State University, Universiteit Maasstricht, Ohio State University, Rice University, Monte Verita Risk Management Conference (Ascona, Switzerland), Federal Reserve Bank of Chicago Annual Conference on Bank Structure and Competition, Global Investment Conference on International Investing (Whistler), and the NYSE Conference on Global Equity Markets in Transition (Hawaii) improved the paper.

This paper studies the full equilibrium dynamics of an economy with financial frictions. Due to highly non-linear amplification effects, the economy is prone to instability and occasionally enters volatile episodes. Risk is endogenous and asset price correlations are high in down turns. In an environment of low exogenous risk experts assume higher leverage making the system more prone to systemic volatility spikes- a volatility paradox. Securitization and derivatives contracts leads to better sharing of exogenous risk but to higher endogenous systemic risk. Financial experts may impose a negative externality on each other by not maintaining adequate capital cushion.

Systemic risk is modeled as the endogenously chosen correlation of returns on assets held by banks. The limited liability of banks and the presence of a negative externality of one bank's failure on the health of other banks give rise to a systemic risk-shifting incentive where all banks undertake correlated investments, thereby increasing economy-wide aggregate risk. Regulatory mechanisms such as bank closure policy and capital adequacy requirements that are commonly based only on a bank's own risk fail to mitigate aggregate risk-shifting incentives, and can, in fact, accentuate systemic risk. Prudential regulation is shown to operate at a collectivelevel, regulating each bank as a function of both its joint (correlated) risk with other banks as well as its individual (bank-specific) risk.

Banks are known to fail either because they are intrinsically insolvent or because an aggregate shortage of liquidity renders them insolvent. We show that the reverse can also happen: bank failures can shrink the common pool of liquidity, leading to a contagion of failures and a possible total meltdown of the system. Given the costs of a meltdown, there is a possible role for government intervention. Unfortunately, liquidity problems and solvency problems interact and can cause each other, making it hard to determine the root cause of a crisis from observable factors. We propose a robust sequence of intervention. Our work suggests the conventional wisdom of helping only solvent but illiquid banks in a crisis has to be rethought. We are grateful to John Cochrane, Isabel Gödde, Nobu Kiyotaki, and three anonymous referees for very helpful comments on an earlier draft, and to Steve Ross and participants at the NBER Economic Fluctuations meetings in February 2001 for helpful suggestions. We are grateful for financial support from the National Science Foundation and the Center for Research on Security Prices. Rajan also thanks the Center for the Study of the State and the Economy for financial support. Many economists would agree that an important role of a central bank is to alleviate a

Luigi Zingales for suggesting that the channel of information spillovers be examined as a source of systemic risk, to Amil Dasgupta, John Moore, and seminar participants at Bank of England,

This paper develops an analytical model of contagion in financial networks with arbitrary structure. We explore how the probability and potential impact of contagion is influenced by aggregate and idiosyncratic shocks, changes in network structure, and asset market liquidity. Our findings suggest that financial systems exhibit a robust-yet-fragile tendency: while the probability of contagion may be low, the effects can be extremely widespread when problems occur. And we suggest why the resilience of the system in withstanding fairly large shocks prior to 2007 should not have been taken as a reliable guide to its future robustness.

The recent accounting scandals at Enron, WorldCom, and Tyco were related to the misrepresentation of liabilities. We provide a structural model of correlated multi-firm default, in which public bond investors are uncertain about the liability-dependent barrier at which individual firms default. In lack of complete information, investors form prior beliefs on the barriers, which they update with the default status information of firms arriving over time. Whenever a firm suddenly defaults, investors learn about the default threshold of closely associated business partner firms. Due to the unpredictable nature of defaults in our model, this updating leads to "contagious" jumps in credit spreads of business partner firms, which correspond to re-assessments of these firms' health by investors. We characterize joint default probabilities and the default dependence structure as assessed by imperfectly informed investors, where we emphasize the the modeling of dependence with copulas.

Robust (cross-border) interbank markets are important for the well functioning of modern financial systems. Yet, a network of interbank exposures may lead to domino effects following the event of an initial bank failure. The "structure" of the interbank market is a potential important driving factor in the risk and impact of interbank contagion. We investigate the evolution of contagion risk for the Belgian banking system over the period 1993-2002 using detailed information on aggregate interbank exposures of individual banks and on large bilateral interbank exposures. We find that a change from a complete structure (where all banks have symmetric links) towards a "multiple money centre" structure (where the money centres are symmetrically linked to some banks, which are themselves not linked together) as well as a more concentrated banking market have decreased the risk and impact of contagion. Moreover, an increase in the proportion of cross-border interbank assets has lowered the risk and impact of local contagion. Yet, this reduction was probably accompanied by an increase in contagion risk generated by foreign banks, although even here the contagion risk appears fairly limited.