A Simple Way to Halt Financial Contagion

While some people view bank runs as rational acts, others find them perplexing. In the latter view, equity investors often appear to sell simply because others are selling, rather than for a more fundamental reason—and this observation held especially true during the 2007–10 financial crisis, when investors rapidly pulled money out of banks, whether they were sound or not.

Chicago Booth PhD candidate Hyunsoo Doh investigates why such damaging cases of financial contagion begin—and suggests ways to structure debt so that runs might be avoided.

Research about bank runs typically considers defaults to be discrete, sequential occurrences, a domino model of contagion: when a bank’s fundamentals deteriorate, investors in both that bank and others start to run. Doh points out that contagion events, including the one experienced during the recent financial crisis, do not play out sequentially, but concurrently.

Take a typical bank, Bank A, which issues a lot of short-term debt securities to meet its financing needs. In Doh’s framework, investors would decide whether to hold or sell the securities on the basis of conditions at competing banks. If it seems likely that another bank will face a run, an investor may worry about the liquidity of securities issued by Bank A, preemptively dump those securities, and prompt other investors to sell securities en masse. This action would destabilize Bank A and other banks. Because all investors are simultaneously making these same calculations, a run can start even at a stable bank; concerns about a potential liquidity crisis can end up spawning a full-blown solvency crisis.

But what if a brake could be applied to this destructive cycle? Doh’s research suggests that a special form of hybrid debt security could be developed to serve a role similar to that of a control rod in a financial reactor core meltdown—it would control a potentially dangerous chain reaction. This hybrid security would have its maturity lengthened in periods of crisis. The aim would be to boost investor confidence, and decrease investor concern about a potential liquidity crisis. That could help stave off the destructive spiral that leads to a solvency crisis.

Some people may believe that it would be possible to deter a run during a crisis by renegotiating and increasing the face value of any outstanding debt. Doh, however, says that this action may have the opposite of the intended effect if the timing is less than perfect, as investors may strategically run earlier to grasp that higher face value.

While the type of flexibly maturing or flexible principal securities Doh proposes are currently only theoretical, his models suggest that continued research in this area, and the development of such securities, would aid financial stability in times of extreme crisis.