Financial Contagion and Shock Transmission During the Global Financial Crisis: A Review of the Literature

Financial Contagion and Shock Transmission During the Global Financial Crisis: A Review of the Literature

Thomas J. Flavin (Maynooth University, Ireland) and Dolores Lagoa-Varela (Universidade da Coruña, Spain)
Copyright: © 2020 |Pages: 25
DOI: 10.4018/978-1-7998-2440-4.ch008
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Abstract

After the recent financial crisis, the analysis of shock transmission across the financial system has received a great deal of attention. In particular, the role of financial contagion as a shock propagation mechanism has been studied in detail. The globalisation of financial and banking markets has increased the connections and relationship between them. Hence, recent crises have spread all around the world. The stability of linkages between financial assets across different market conditions cast doubt upon the benefits of portfolio diversification. This chapter reviews the extant literature on financial contagion during the global financial crisis and thus provides information for both portfolio managers (when optimizing their investment portfolios) and policymakers (when designing their strategies in order to mitigate spillover effects during crisis periods).
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Background

It is now generally accepted that the origins of the U.S. credit crisis lay in the market for securitized products, such as Collateralized Debt Obligations and other complex credit derivatives whose underlying pool of income-generating assets were becoming increasingly concentrated in the U.S. real estate sector, and in particular, on subprime mortgages, see Brunnermeier (2008), Gorton (2009) and Dungey et al. (2013) among others. The spectacular growth of this sector in the early 2000s and its subsequent decline led to widespread financial turbulence for the banking industry. It’s interesting to note that this sector of the financial system was relatively small. Dywer and Tkac (2009) estimate that as of December 2006, this market segment accounted for only about 1% of global bond values, stock values and bank deposits. Yet, the sudden decline of this market triggered the most widespread financial market decline since 1929. Consequently, the question of how such a small sector created such a global financial crisis and economic recession has spawned a burgeoning literature. The extant literature has already shown that banking crisis often have severe repercussions for the real economy. Bernanke (1983) shows that banking crashes have the potential to trigger recessionary periods in the real economy and this is backed up by empirical evidence presented in Reinhart and Rogoff (2009), even though Dwyer et al. (2013) report examples of where banking crisis did not translate into economic recessions. Tong and Wei (2009) identify two channels through which the banking crisis may be transmitted to the real economy; the finance channel and the demand channel. The former refers to the reduction in credit availability for non-financial firms and the latter refers to the reduced demand for goods and services by consumers.

This is the literature that we review here, and in particular we examine the role of contagion in the transmission of the shock. Specifically, we propose to structure the work in the following sections:

Key Terms in this Chapter

De-Coupling: When the transmission mechanism is dampened in the crisis regime or the response is statistically significantly lower than expected given market interdependence.

Financial Contagion: A situation where sudden large losses in one country, one sector or one particular asset spread out across the economy and increase the risk of subsequent large losses in the same as well as in other countries, sectors or assets.

Safe Haven Asset: An investment with low market risk and high liquidity that is sought by investors to limit their exposure to losses during market downturns.

Credit Constraints: Gradual tightening of lending rules as well as credit rationing by financial intermediaries to companies.

Spillover Effects: Secondary effects or collateral effects.

Global Financial Crisis: Period of extreme stress in global financial markets and banking systems between mid-2007 and early 2009.

Flight to Safety: Investors buy bonds (safer investments) when they sell stocks (higher-risk investments) in order to reduce the losses that investors suffer in crises periods.

Economic Downturns: A period of an economic contraction, sometimes limited in scope or duration

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