Capital, Contagion, and Financial Crises: What Stops a Run from Spreading?
45 Pages Posted: 25 Aug 2019
Date Written: August 21, 2019
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: Suggested Citation