Financial Contagion in a Two‐Country Model

• Published date: 01 October 2022
• Author: TARISHI MATSUOKA
• Date: 01 October 2022
• DOI: http://doi.org/10.1111/jmcb.12887

DOI: 10.1111/jmcb.12887

TARISHI MATSUOKA

Financial Contagion in a Two-Country Model

This paper studies a two-country version of the standard banking model with

nancial markets to investigate the effects of nancial marketglobalization

on nancial stability. In autarky, two types of banks arise endogenously:

some always remain solvent and others can default.When the nancial mar-

kets are integrated, three types of banks can arise endogenously, and some

banks go bankrupt because of the liquidity shock of another country. I show

that nancial market globalization can cause nancial contagion and reduce

welfare. In addition, the endogenous heterogeneous risk prole of the two

countries can be observed.

JEL codes E4, F4, G2

Keywords: nancial contagion, liquidity, banking, asset price,

two-country model

I    , there has been an extensive de-

bate on the effects of nancial market globalization. The conventional view is that

this allows countries to share risk and liquidity and reduce consumption volatility.

However, there is substantial evidence that nancial market globalization in many

parts of the world since the 1980s has made nancial crises more frequent, costlier,

and more linked. Notable examples include the Asian crisis of 1997–98, the Russian

crisis of 1998, and the global nancial crisis of 2007–08.

A number of researchers have developed models where a crisis in one country (or

region) is spread by contagion to other countries (or regions). For example, Allen

and Gale (2000) focus on a channel of contagion that arises from the overlapping

claims that different banking systems haveon each other. They show that the spread of

banking failure can occur through interbank markets. Allen and Gale (2004a, 2004b)

develop a stylized banking model with nancial markets and show that contagion

occurs because of a fall in asset prices due to the liquidation of some banks’ assets,

I am grateful to Kiminori Matsuyama, Ryoji Hiraguchi, Akihisa Shibata, and YuAwaya for their many

insightful comments and suggestions. Thanks are also due to participants at SWET 2016 at Otaru and at

2016 Japanese Economic Association Autumn Meeting at Waseda University for useful comments and

feedbacks. This work was supported by JSPS KAKENHI Grant Numbers JP26780123 and JP17K13703.

All remaining errors are mine.

TM is with the Faculty of Economics and Business Administration, TokyoMetropolitan

University (E-mail: matsuoka-tarishi@tmu.ac.jp).

Received December 23, 2019; and accepted in revised form November 8, 2021.

Journal of Money, Credit and Banking, Vol. 54, No. 7 (October 2022)

© 2021 The Ohio State University.

2150 :MONEY,CREDIT AND BANKING

which exerts strain on other banks. While the former model assumes the exogenous

liquidation values of assets, the latter endogenizes them.

In this paper, in order to study the relationship between nancial market global-

ization and nancial contagion, I propose an alternative form of the model developed

by Allen and Gale (2004a, 2004b) by considering two large countries in the world

economy. There are three dates as usual. Each country consists of a continuum of

agents who have random liquidity preference, which generates an endogenous role

for banks, as in Diamond and Dybvig (1983). The banks hold short-term assets or

long-term assets with a higher return and face aggregate uncertainty about demands

for liquidity from their customers at the second date. The basic role of nancial as-

set markets is to reallocate liquidity from banks with high liquidity to banks with

low liquidity.

I start with the analysis of the optimal behaviors of banks in autarkic equilibrium.

As in Allen and Gale (2004a, 2004b), two types of banks can arise endogenously:

some banks always remain solvent, and others can experience a run and thus go

bankrupt. The cash-in-the-market pricing can be observed. I then examine the ef-

fects of nancial market globalization because of which the two banking systems are

linked through the common interbank asset markets. The markets reallocate global

liquidity from banks with high liquidity in one country to banks with low liquidity

in the other country. Despite the potential benet of risk sharing, nancial contagion

can be observed as an equilibrium phenomenon. The banking failures in one country

can cause a fall in asset prices, which in turn puts banks in the other country under

severe strain and bankruptcy.

Although the mechanism behind contagion in this model is essentially the same as

that of Allen and Gale (2004a, 2004b) but not as that of Allen and Gale (2000), the

equilibria in this model have properties that are not shared by those in their model.

First, more than two types of banks, which have different portfolio strategies, can

arise endogenously. Some types of banks go bankrupt because of the liquidity shock

of the other country. Financial market globalization can cause nancial contagion.

Second, nancial market globalization can reduce welfare despite it induces not only

risk sharing between the countries but also banking defaults that relax the constraint of

incomplete deposit contracts (Allen and Gale 1998, 2004a). This is because the inef-

cient liquidation of the long-term asset increases owing to the contagion. Third, there

exists a continuum of asymmetric equilibria, where the two countries have different

shares of defaulting banks. The ex ante symmetric countries can be endogenously

divided into safe and risky types after nancial market globalization. The endoge-

nous determination of global nancial risks is central to the analysis of this paper and

makes a signicant contribution to the literature.

My analysis has some relevance to the failures of European banks such as BNP

Paribas (in France), Northern Rock (in the United Kingdom [UK]), and IKB (in

Germany) in the summer of 2007. These banks held a large amount of mortgage

assets funded with very short-term liabilities and experienced a liquidity crisis

after the collapse of the United States (U.S.) nancial system. This spillover to the

European banks was caused by the decline in the asset values of complex global