Understanding the Mechanics of Contagion in Financial Markets

[This is another of a series of editorials by Executive Editor Andrew Karolyi at the Review of Financial Studies featuring recently published papers at the journal. This editorial features “Financing Constraints and the Amplification of Aggregate Downturns” by Daniel Carvalho of the University of Southern California, an article in Issue 28(9) for September 2015. It was selected as an Editor’s Choice article on the Oxford University Press web site for RFS.]

About a year ago, I posted a blog entitled “Wherefore art thou (corporate) peer?” in which I featured the work of Cecilia Bustamante, now of the University of Maryland, and her study on “Strategic Investment and Industry Risk Dynamics” in Issue 28(2), February 2015. I reflected on the large and growing literature on peer effects in Economics and the challenges of pinning down the positive/negative externalities among peers given correlated effects, Manski’s (1993) “reflection problem,” and such like. Cecilia’s study featured what I called a “twist” in its focus on firms’ strategic interactions with product-market peers.

below-257882_640-pixabayFast forward half a year and we find another fascinating study of industry peer effects, but this time focusing on financing, especially in market downturns. Daniel Carvalho’s paper identifies financial contagion effects during industry declines in which financially-constrained firms impose negative externalities on each other and in which the severity of the declines are significantly amplified. We have known about amplification effects from lots of theories in both Macroeconomics and Finance and they often feature the importance of financing frictions. The work of Ben Bernanke, Mark Gertler, and Simon Gilchrist in the 1990s is the reference point for many of us. Taking this kind of analysis to the industry level is what is novel toward pinning down the channels of influence with greater precision. Daniel’s work uncovers positive evidence on the mechanism through which these industry-specific amplification effects arise: the adverse impact of financially-constrained firms on the balance-sheets of their industry peers. When all firms in an industry face greater financing constraints, asset prices are lower, and firms have a harder time selling their assets to cover short-falls or borrowing against the collateral value of those assets.

When I asked Daniel to define the contribution of his work that many readers would miss, he emphasized the effects of financing frictions at the industry level. He pointed out that it is natural to think about general equilibrium effects as mitigating the importance of financing frictions at the aggregate level and not in exacerbating them. For him, it is all about how they can be downright destabilizing during industry downturns and across a range of industries. These externalities can lead to what Daniel calls “socially inefficient” corporate financial policies.

So, the most important takeaway here is the contrast between individual (firm) and aggregate (in this case, industry) effects of financial frictions and the need to incorporate these indirect contagion effects to get a clearer picture of what we observe in corporate finance research. Ironically, Cecilia Bustamante’s study of industry peer effects called for a revisionist perspective on portfolio sorting techniques for asset pricing tests defined by a firm’s relative position within its own industry.

Is there an echo in here?

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