Financial crisis too easily blamed on ‘contagion’

The financial crisis is too easily blamed on the effect of ‘contagion’ of one bank by another, while banks being unduly vulnerable as a result of their all being exposed to the same market developments goes relatively unnoticed. This is one of the conclusions of PhD research into the stability of the financial sector conducted by economist Mark Mink. He will be awarded a PhD by the University of Groningen on 20 September 2012.

If the extremely unpredictable domino effect – where one bank going under leads to another bank failing – is immediately blamed, the fact that banks can fail simultaneously because they were all exposed to the same risks is insufficiently acknowledged. ‘There’s quite a difference between a healthy bank being surprised by sudden contagious effects, or the bank just having been too trusting that American house prices would continue to rise or that short-term market funding would remain available indefinitely’, says Mink.

Domino effect

In his research into the stability of the financial system, Mink distinguishes between a domino effect on the one hand, and a gust of wind toppling all the dominos on the other. He used this in a comprehensive data analysis of the financial markets since 2007, when the bank crisis struck. The results show that the market value of the banks is strongly correlated, but that these market values are hardly affected by changes in the chances of other banks going bankrupt. This result implies that the contagious effects only played a minor role in the decreasing market value of the banks. Mink: ‘It’s not easy to distinguish between these two effects. Roughly speaking, you could say that where contagion is concerned, the instability of one bank is caused by the instability of another institution. If there is no causal relationship, this means that a common shock is the cause.’

Homogeneity

To prevent such a common shock from destabilizing a complete sector, it is important that banks become less homogeneous, Mink concludes:  ‘It could be in the best interests of society for banks to become more specialized. Financial stability is increased by decreasing the similarities between bank balances. Otherwise they will all be vulnerable to the same types of shocks and market developments, causing them all to run into trouble simultaneously.’

Salvage operations

This conclusion has consequences for salvage operations for banks. The irony is that the theoretical part of the thesis shows that the possibility of liquidity support being provided by, for example, the ECB, tends to make banks resemble one another more closely. Mink: ‘If common shocks are indeed the major cause of instability, saving one bank mainly tends to have a stabilizing effect because it shows the other banks that if necessary they too can count on state support.’ The analysis also shows that those banks that according to market parties have little to fear from a Greek bankruptcy can still see their stock prices rise when news of an imminent Greek salvage operation emerges. ‘When a crisis is at its peak, such salvage operations therefore do have a stabilizing effect, yet they can also become a source of instability when doubts arise in the marketplace concerning the ability of governments to stand by their implicit guarantees. Luckily, work is being done on how to make a gradual cutback possible.’

Curriculum vitae

Mark Mink (Leidschendam, 1980) studied General Economics at the University of Groningen. Since late 2007 he has been employed as an economist by the department of Supervisory Strategy at De Nederlandsche Bank. Mink will be awarded his PhD on Thursday 20 September by the Faculty of Economics and Business. His thesis is entitled ‘Financial System Instability: Contagion, or Common Shocks?’ His supervisors were Prof. Jakob de Haan and Dr Jan P.A.M. Jacobs. On 1 November, Mink will begin work for a year at the Division of Research & Statistics of the Federal Reserve Board of Governors in Washington, D.C.

Note for the press

For more information: Mark Mink, e-mail: m.mink rug.nl or tel. 020 524 9111.