Financial Contagion through Capital Connections: A Model of the Origin and Spread of Bank Panics

Abstract

Financial contagion is modeled as an equilibrium phenomenon in a dynamic setting with incomplete information and multiple banks. The equilibrium probability of bank failure is uniquely determined. We explore how the cross-holding of deposits motivated by imperfectly correlated regional liquidity shocks can lead to contagious effects conditional on the failure of a financial institution. We show that contagious bank failure occurs with positive probability in the unique equilibrium of the economy and demonstrate that the presence of such contagion risk can prevent banks from perfectly insuring each other against liquidity shocks via the cross-holding of deposits.