Coordination Failure and Financial Contagion

Manz, Michael (March 2002). Coordination Failure and Financial Contagion (Diskussionsschriften 02-03). Bern: Universität Bern Volkswirtschaftliches Institut

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This paper explores a unique equilibrium model of îinformationalî financial contagion. Extending the global game model of Morris and Shin (1999), I show that the failure of a single firm can trigger a chain of failures merely by affecting the behavior of investors. In contrast to the existing multiple equilibria models of financial and banking panics, there is no indeterminacy in the present model. Thus, it provides a clear framework to assess the consequences of contagion and yields some important and hitherto unnoticed insights. Most importantly, if contagion is compared to an appropriate benchmark, its impact can be both positive or negative, which contrasts sharply with the traditional view of contagion. Moreover, contagion increases the correlation between firms, but the effect on the unconditional probability of failure is exactly zero.

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