Financial Contagion through Capital Connections: A Model of the Origin and Spread of Bank Panics∗†

Financial contagion is modeled as an equilibrium phenomenon in a dynamic setting with incomplete information and multiple banks. The equilibrium probability of bank failure is uniquely determined. We explore how the cross holding of deposits motivated by imperfectly correlated regional liquidity shocks can lead to contagious effects conditional on the failure of a financial institution. We show that contagious bank failure occurs with positive probability in the unique equilibrium of the economy and demonstrate that the presence of such contagion risk can prevent banks from perfectly insuring each other against liquidity shocks via the cross-holding of deposits. (JEL: G2, C7) ∗Acknowledgements: I am grateful to the editors, Franklin Allen and Patrick Bolton, and to two anonymous referees for detailed and helpful comments. This paper is a revised version of a chapter of my Ph.D. dissertation at Yale University. I would like to thank my advisor, Stephen Morris, and committee members, Ben Polak and Dirk Bergemann for their guidance. This paper has benefited from discussions with V. V. Chari, Itay Goldstein, Timothy Guinnane, Patrick Kehoe, Jonathan Levin, John Moore, Ady Pauzner, Debraj Ray, Andreas Roider, and Hyun Shin. I thank Elu von Thadden for his insightful discussion of this paper at the CFS Conference on Liquidity Concepts and Financial Instabilities, 2003, and seminar participants at LBS, LSE, the Bank of England, and Yale, for comments. Financial support from the Yale’s Cowles Foundation and Northwestern’s CMS-EMS is gratefully acknowledged. All remaining errors are my own. †Email address: [email protected]