Module 4, Section 2: Bank Contagion

Overview of Module 4, Section 2: Bank Contagion, which is defined as the failure of one bank leading to the failure of another bank due to the interconnected nature of the financial system. The major sources of bank contagion are outlined as well as the structural elements that amplify it and the inherent trade-offs associated with a global banking system.

Main Themes

Interconnectedness as the Foundation of Contagion Banks do not operate in isolation and their interconnectedness is the primary pathway for contagion. This interconnectedness is essential for a functional global financial system, enabling large investments, innovation, and lower interest rates.

Multiple Mechanisms of Contagion

• Decrease in Bank Lending (Wholesale Credit Crunch) When a bank that lends on the wholesale market faces a crisis, banks that rely on this funding face increased "stable funding risk," leading to a potential credit crunch.

• Increase in Bank Loan Default Conversely, if a bank that borrows on the wholesale market fails, banks that lent to it face "increased capital inadequacy risk" due to the non-repayment of loans.
• Decrease in Asset Values (Fire Sales) When a bank in distress rapidly sells long-term assets to improve liquidity (a "fire sale"), it can drive down the market price of those assets. Banks holding similar assets then experience a decrease in their asset values and face "increased capital inadequacy risk."
• Insolvency of Credit Default Insurance Providers If a major provider of credit default swaps (insurance against asset value decline) becomes insolvent and cannot fulfill its obligations, banks that relied on this insurance face "increased capital inadequacy risk" as the protected value of their assets is now at risk.

Structural Factors Magnifying Contagion

• Size: Larger institutions have a greater ability to impact other entities. For example, a major wholesale lender leaving the wholesale market.
• Interconnectedness: The more direct connections an organization has, the more pathways exist for contagion. For example, a major credit default insurer in the industry becoming insolvent.
• Centrality: Entities that bridge disparate networks can transmit crises across different segments of the industry. For example, a global bank with assets and liabilities spanning countries.
• Industry Correlation: When many banks hold similar assets, a negative shock affecting those assets can simultaneously impact numerous institutions, amplifying the crisis. For example, banks investing in the same types of Asset Backed Securities.

Systemic Risk vs. Individual Bank Risk There is a differentiation between risks specific to an individual bank (like liquidity risk) and systemic risk arising from the interconnectedness of the system.

Trade-offs of a Global Financial System: A trade-off exists between the benefits of a highly interconnected global financial system (e.g., facilitating large loans and innovation) and the inherent risk of contagion. Avoiding all risk (isolation) has its own significant drawbacks. Society must decide on the acceptable balance of risk to reap the rewards of a global banking system.

Limitations of Risk Mitigation: While individual banks can manage some risks (like counterparty risk in lending), certain sources of contagion are largely beyond the control of individual institutions. The example of AIG's potential failure due to Lehman Brothers' collapse illustrates this point, where even responsible actors can be affected