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Contagion of a Liquidity Crisis Between Two Firms

Economic Research Institute 2012.04.23 3936

This paper presents a model in which the contagion of a liquidity crisis
between two nonfinancial institutions occurs because of learning activity
within a common creditor pool. After creditors observe what occurs in a
rollover game for a firm, they conjecture one another’s “type” or attitude
toward the risk associated with the firm’s investment project. Creditors’
inference about one another’s type then influences their decision to lend to
the next firm. By providing an analysis of the “incidence of failure” (the
threshold for a liquidity crisis) for each firm, this paper demonstrates that
the risk of contagion increases sharply if it originates ex ante from a firm
facing a low probability of failure. In addition, the paper proposes some
policy measures for mitigating the severity of contagion during a liquidity