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In financial ecosystems, big banks trample economic habitats and spread fiscal disease
Date:11/14/2012

s that speed transmission. But while isolation can stem a biological virus, financial "contagions" feed on anxiety.

"An important distinction from biological disease is that financial contagions become more virulent and transmissible the more anxious people become," Arinaminpathy said. "We capture the well-observed phenomenon that a loss of confidence creates a cycle of financial and psychological insecurity. The worse confidence gets, the more severe those financial shocks get."

Bank sick day

The researchers' financial models contained 200 banks and three "contagion channels" that introduce illness into the system liquidity hoarding, the spread of defaults and a collapse in asset value (such as mortgages). Though these avenues of financial crisis have been examined individually, Kapadia said, he and his co-authors are the first to demonstrate how they interact with one another and with system wide confidence.

The central model contained eight large banks and 192 smaller banks, all with equal capital and cash. The researchers selected a random bank for sudden failure and measured how that affected the entire bank system through each of the three contagion channels. It was in this model that financial trouble in one bank could create a tide of uncertainty that caused widespread distress in the system. Yet, catastrophe could be averted more often if large banks have backup capital commensurate with their size.

Notably, in these simulations, when a large bank collapsed the probability of the system collapsing as a result exceeded 16 percent. There was no such risk when a small bank failed. The impact was highly localized and the probability that more than three additional banks would falter was less than 2 percent.

"The models aren't set up to make quantitative estimates, but rather to show that if they fail, larger banks will have a more-than-proportionate impact on the financial system than smaller banks,"
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Contact: Morgan Kelly
mgnkelly@princeton.edu
609-258-5729
Princeton University
Source:Eurekalert

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