The literature presented so far focuses only on the direct links between the balance sheets of financial institutions. The default of one financial institution on its obligations leads to losses on the balance sheets of other financial institutions, which may lead to further defaults, and so on. This type of contagion is often referred as “domino” contagion or cascade bank failures. A key assumption common to these models is that the price of the assets that financial institutions have in their balance sheets is fixed. However, a model assuming this may lead to too conservative results, since banks often operate in highly volatile markets and this provides an additional channel through which contagion can spread through the system.
The distinction…show more content… Mark-to-market accounting is a key assumption made in the model described above which facilitates contagion through common portfolio holdings. In recent years there has been a considerable debate on the advantages and disadvantages of mark-to-market or fair-value accounting (FVA). Proponents argue that fair values for assets or liabilities reflect current market conditions and hence provide timely information, thereby increasing transparency and encouraging prompt corrective actions. Opponents claim that fair value is not relevant and potentially misleading for assets that are held for a long period and, in particular, to maturity; that prices could be distorted by market inefficiencies, investor irrationality or liquidity problems; that fair values based on models are not reliable; and that FVA contributes to the procyclicality of the financial…show more content… The authors analyzed the direct channel of financial contagion through balance sheet cross-exposures. The financial system is modeled as a network of financial flows which interconnect the financial institutions with one another as well as financial institutions with outside agents (sinks), which could be households, shareholders, etc. A negative shock that affects the assets of one intermediary leads to a decrease in its firm value and hence a decrease in the price of its outstanding debt. In the financial system, however, debt issued by one company is hold as an asset by another company. The debt holder, in as much as it uses mark-to-market accounting, suffer a loss that, in turn, worsens its own balance sheets and shrinks the market value of their own outstanding debt. In turn, this loss is borne by the subscribers of such debt, and so forth and so on along the chains of financial obligations, diffusing and amplifying the initial negative shock. Thus, the authors show that financial contagion can be transmitted in the system even without any agent experiencing a default, which was a key factor for triggering contagion in the models reviewed so far. Moreover, they prove that financial networks are more exposed to direct default contagion with the mark-to-market regime than with the historical cost regime, both in terms of contagion scope (the number of defaults)