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• W1586370842 abstract "I. INTRODUCTION The Too Big to Fail banking policies have been mostly motivated by fears of systemic risk. Systemic risk, as a concept, refers to the idea of chain reaction and highly correlated waves of bankruptcies that threaten the financial system and would prevent it from playing its intermediation role in the economy. Taylor (2010) defines it as a three-step event: (1) the failure of a large financial institution triggering the systemic event, (2) financial contagion and (3) transmission to so-called real economy. Financial contagion refers here to the way the bankruptcy of a financial institution spills over to another one, but a broader interpretation of financial contagion would be successive correlated price declines (or losses) on a market, regardless of the bankruptcies it might or might not entail. It does not refer to long-term systematic confidence crises characterized by growth stagnation and a dearth of investment. This document will focus primarily on financial contagion, specifically financial contagion in the banking sector, and its implications for Too Big to Fail policies. But the systemic risk literature is also very much interested in the non-financial industry, where results largely differ (1). There are two distinct types of financial contagion affecting financial institutions: counterparty contagion and informational contagion. Both have the common idea that the first failure responsible for the contagion should be a systemically important financial institution (SIFI). TBTF banks, or SIFIs, is a qualifier often defined in terms of turnover, but the concept goes beyond to take account of its role in the market and, in the case of banks, its function in the banking system. For example, a bank that would not be of significant size but would assume the role of clearing house, correspondent bank or prime broker would be likely to endanger the system and be a candidate for the status of SIFI or TBTF, or sometimes Too Interconnected to Fail. Of course, the size and role of banks often go together. However, there is no formal way to define systemically threatening firms in the economic literature, and authorities long refused to provide information on which institution they considered too big to fail, given the significant moral hazard problem it would entail. Counterparty contagion theory involves direct links between financial institutions through counterparty risk. The default of the first firm on its obligations would transmit financial distress to its creditors, who would forward it to their own creditors and so on until the crisis is widespread. The dominos metaphor is often used to illustrate these scenarios. The second type of contagion is informational contagion. According to informational contagion theory (1), contagion spreads because the financial difficulties of the initial bankrupt firm reveals information on a risk shared by both firms. Contagion occurs because the information needed to determine how similar firms, or securities, are affected by this 3rd party risk is not immediately available, requires a costly analysis, and the creditors of these subsequent firms are risk averse. This type of contagion is manifested by bank runs, panics, and confidence crisis. This type of contagion can lead to significant losses in the financial system without necessarily leading to bankruptcies. This contagion affects solvent and insolvent institutions alike. Whether from counterparty risk or informational, financial contagion is often illustrated with metaphors: dominoes falling one after the other, the failure of an institution that would block the plumbing of the financial system, etc. Metaphors can be useful for vulgarization, but one needs to be careful when using them as they influence the way we think about the underlying phenomenon. For example, the dominoes metaphor captures quite perfectly the narrative of counterparty contagion, but Kaufman and Scott (2003) suggest that informational contagion might better be thought of as the collapse of a single or a few dominos, pushing to question the stability of surrounding dominoes. …" @default.
• W1586370842 created "2016-06-24" @default.
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• W1586370842 date "2012-07-01" @default.
• W1586370842 modified "2023-09-23" @default.
• W1586370842 title "Are Dominos a Good Metaphor for Systemic Risk in Banking" @default.
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