Capital, Contagion, and Financial Crises: What Stops a Run from Spreading?

45 Pages Posted: 25 Aug 2019

See all articles by Nicholas Kean Tabor

Nicholas Kean Tabor

Board of Governors of the Federal Reserve System

Jeffery Zhang

Board of Governors of the Federal Reserve System

Date Written: August 21, 2019

Abstract

After the 2008 financial crisis, policymakers focused on enacting improvements in two areas of financial regulation: capital and liquidity, affecting the composition of bank assets and the sources of bank funding. These improvements made both the emergence of a crisis less likely and the recovery from one more rapid. This article suggests, however, that post-crisis reforms did not address a distinct and critical third task: how to limit the damage — to other firms, and to the financial system — once a panic begins.

Using data on share prices and credit default swaps, we show that — at their low pre-crisis levels — the balance-sheet liquidity and regulatory capital of a banking institution did not predict the impact of the September 15, 2008 run on Lehman Brothers on that institution. On the contrary, in some markets, banks with greater balance-sheet liquidity and regulatory capital were more exposed — not less — to the resulting panic, and the higher their levels of regulatory capital, the more they relied on debt for funding. By contrast, we show that simple share-price correlation was a powerful predictor of run exposure, and that market valuations of large banks are more highly correlated today than they were in September 2008. This increase in correlation implies a convergence in the banks’ business models, which could offer a ready conduit for an unexpected shock to metastasize into a contagious run.

The views expressed in this article are the authors’ alone and do not necessarily reflect the views of the Federal Reserve Board or the United States government.

Keywords: financial regulation, banking capital, banking liquidity, financial crises

JEL Classification: G1, G2, G15, G18, G20, G21, K2

Suggested Citation

Tabor, Nicholas and Zhang, Jeffery, Capital, Contagion, and Financial Crises: What Stops a Run from Spreading? (August 21, 2019). Available at SSRN: https://ssrn.com/abstract=3440970 or http://dx.doi.org/10.2139/ssrn.3440970

Nicholas Tabor (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Jeffery Zhang

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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