There are several branches of literatures explaining the mechanism of financial contagion.
One branch of them emphasizes contagious currency crises, relating such crises to various monetary and financial sector vulnerabilities and trade factors. These studies often look for the underlying causes behind a simultaneous set of speculative attacks. For instance, Goldfajn and valdés (1997) find that the intermediaries' role of transforming maturities is shown to result in larger movements of capital and a higher probability of crisis, which resemble the observed cycle in capital flows: large inflows, crisis and abrupt outflows. Kaminsky and Reinhart (2000) document the evidence that trade links in goods and services and exposure to a common creditor can explain earlier crises clusters, not only the debt crisis of the early 1980s and 1990s, but also the observed historical pattern of contagion.
The second branch of literatures explain contagion transmission as a result of linkages among financial institutions. Alen and Gale (2000), and Lagunoff and Schreft (2001) analyze financial contagion as a result of linkages among financial intermediaries. The former provide a general equilibrium model to explain a small liquidity preference shock in one region can spread by contagion throughout the economy and the possibility of contagion depends strongly on the completeness of the structure of interregional claims. The latter proposed a dynamic stochastic game-theoretic model of financial fragility, through which they explain interrelated portfolios and payment commitments forge financial linkages among agents and thus make two related types of financial crisis can occur in response.
In addition, Van Rijckeghem and Weder (2000), presents evidence that spillovers through bank lending contributed to the transmission of currency crises during the recent episodes of ﬁnancial instability in emerging markets. Besides, in an era of rapid financial globalisation, Gai and Kapadia (2010), prove that while high connectivity may increase the spread of financial contagion and adverse aggregate shocks and liquidity risk also amplify the likelihood and extent of financial contagion.
The third branch emphasize financial contagion among financial markets. This stream of researches try to explain contagion through a correlated information or a correlated liquidity shock channel. Under the correlated information channel, price changes in one market are perceived as having implications for the values of assets in other markets, causing their prices to change as well (King and Wadhwani (1990)). Also,Calvo (1999) argues for correlated liquidity shock channel meaning that when some market participants need to liquidate and withdrawal some of their assets to obtain cash, perhaps after experiencing an unexpected loss in another country and need to restore capital adequacy ratios. This behavior will effectively transmit the shock.
In addition, there are some less-developed explanations for financial contagion. Some explanations for financial contagion, especially after the Russian default in 1998, are based on changes in investor “psychology”, “attitude” and “behavior”. This stream of research date back to early studies of crowd psychology of Mackay (1841) and classical early models of disease diffusion were applied to financial markets by Shiller (1984). Also, Kirman (1993) analyses a simple model of influence that is motivated by the foraging behaviour of ants, but applicable, he argues, to the behaviour of stock market investors. Faced with a choice between two identical piles of food, ants switch periodically from one pile to the other. Kirman supposes that there are N ants and that each switches randomly between piles with probability ε (this prevents the system getting stuck with all at one pile or the other), and imitates a randomly chosen other ant with probability δ. Eichengreen, Hale and Mody (2008) focus on the transmission of recent crises through the market for developing country debt. They find the impact of changes in market sentiment tends to be limited to the original region. They also find market sentiments can more influence prices but less on quantities in Latin America, compared with Asian countries.
Besides, there are some researches on geographic factors driving the contagion. De Gregorio and Valdes (2001) examine how the 1982 debt crisis, the 1994 Mexican crisis, and the 1997 Asian crisis spread to a sample of twenty other countries. They find that a neighborhood effect is the strongest determinant of which countries suffer from contagion. Trade links and pre-crisis growth similarities are also important, although to a lesser extent than the neighborhood effect.
Read more about this topic: Contagion Effect
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