Project Details
Projekt
Financial contagion through market prices - Theory and evidence
Subject Area
Economic Theory
Term
from 2012 to 2019
Project identifier
Deutsche Forschungsgemeinschaft (DFG) - Project number 201609602
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 possibility of banks holding fungible assets and endogenous price discounts when selling assets. The theoretical model will be used to derive specific hypotheses, which are tested in the second part of the project. The empirical analysis is based on a detailed data set on German banks' transactions in own securities 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.
DFG Programme
Priority Programmes
Cooperation Partner
Natalia Podlich
