Contagion and self-fulfilling dynamics
Contagion and self-fulfilling feedback loops are propagation mechanisms at the heart of systemic financial crises. Contagion refers to the deterioration of fundamentals through the financial network, often through a cascade of insolvencies. A critical factor is the similarity of assets held by financial institutions. The commonality of assets erases some of the benefits of diversification because it facilitates contagion. The potential role of investment funds in aggravating contagion through fire sales has much increased over the past 20 years. Self-fulfilling feedback loops denote the shift from one equilibrium to another, possibly without a change in ‘fundamentals’. They arise from multiple equilibria and strong interdependencies in a financial network. Bank runs are a classic example. Simple metrics that track both types of systemic risk are principal components and cross-correlation coefficients of different types of financial assets.