The subprime mortgage crisis in the United States gave rise to the global financial crisis of 2007–2009, which had a significant effect on equities markets across the globe. There is strong evidence to support investigating the mechanics of crisis transmission and contagion across international borders during this pivotal moment in financial history. In this study, Geert Bekaert, Michael Ehrmann, Marcel Fratzscher, and Arnaud Mehl explore this phenomenon and provide a sophisticated examination of the contagion effects that occurred in the equities markets during the world financial crisis (Bekaert et al. 2014). To provide insight into the complex mechanics of financial contagion, their paper, "The Global Crisis and Equity Market Contagion," painstakingly explores how the crisis affected 415 country-industry equity portfolios.
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In international finance, there has been a lot of interest in and research on the idea of market contagion, which describes how financial crises in one nation or industry spread to others. The October 1987 stock market meltdown is recognised as having established the groundwork for comprehending the cross-border transmission of shocks. Researchers have been proposing various quantitative measures of contagion and developing theories. The first significant global financial crisis has been the Great Depression that occurred between 2007 and 2009 offers a unique testing ground for these hypotheses. The crisis has been started in a tiny but significant area of the US lending market and quickly spread to other financial and global economies (Bekaert et al. 2014).
Theoretical models and empirical research complement Bekaert et al.'s understanding of market contagion during the 2007–2009 financial crises. Understanding how liquidity crises can spread throughout the financial system, resulting in bank defaults and related losses for banks that unintentionally hold failing institutions, is made possible by the utilisation of the bank-run model which was established by Allen and Gale (Bekaert et al. 2014). This paradigm is essential to understanding the interconnectedness of financial firms and the potential for systemic breakdowns.
The concept of the "common creditor problem," which has been studied in study is another crucial element. It enhances the potential for contagion between nations connected by common banking creditors since financial hardship in one nation can quickly spread to others due to these shared financial links.
Bekaert et al. also explore how enterprises were affected by interest rate exposure and financial restrictions during the crisis. They point out that companies that had a large amount of long-term debt maturing during the crisis were especially vulnerable and saw a large decline in investment (Bekaert et al. 2014). The financial constraints measure created by Whited and Wu (2006) sheds more light on this topic by showing how a firm's pre-existing financial constraints may make it more vulnerable to shocks from the financial world.
The study measures the amount of claims local banks have against U.S. banks or other foreign banks empirically using data from the Bank for Foreign Settlements. This information is essential for evaluating the banking industry's direct and indirect exposure to crises since it gives an accurate estimation of the danger of contagion.
The analysis concludes by discussing the role that trade and financial integration play in contagion and argues that greater integration can make people more vulnerable to shocks. This is particularly relevant when external integration efforts are connected to exposures to foreign factors, as this could cause changes in market dynamics during hard times.
Critical Analysis of the Findings
Hypotheses and Research Question
The main objective of Bekaert et al.'s research is to detect and examine contagion in the global equity markets during the financial crisis of 2007–2009. The central premise posits that the crisis sparked contagion, which is characterised as comovements in equity markets that go beyond what preexisting interdependencies or market fundamentals can account for. The research question probes how and why the crisis spread so dramatically across countries and sectors, considering various factors like U.S. contagion, global contagion, domestic contagion, and residual contagion.
Sample and Variables
The research focuses on 415 country-industry equity portfolios from 55 different nations, covering a wide range of international markets. A three-factor model that integrates U.S.-specific, global financial, and local factors is crucial for analysing market movements and possible contagion channels. The authors' unique factor model is one of their strongest methodological features. They can forecast crisis returns and distinguish between contagion and typical market comovements (interdependence) thanks to this approach. By contrasting the model's projected and actual market movements during the crisis, the study can identify any excess comovements that could be signs of contagion.
The research conducted by Bekaert et al. on "The Global Crisis and Equity Market Contagion" yields valuable insights into the complex dynamics of interdependence and contagion that occurred during the financial crisis of 2007–2009. The research reveals notable variations in the spread of contagion among distinct country-sector stock portfolios. This is ascribed to multiple elements such as government policies, banking exposures, external trade and financial connections, and local macroeconomic fundamentals. The significant influence of banking relationships and credit expansion on domestic contagion is an important finding, indicating that heightened vulnerabilities in the financial sector were a major factor in the crisis spreading within nations. Furthermore, the efficiency of governmental actions in preventing contagion emphasises how important policy responses are in times of financial instability.
The research indicates a decoupling from global financial networks in reaction to the crisis, which runs counter to the globalisation concept, by showing a decline in reliance on outside variables during the crisis. This implies a reorganisation of market dynamics in times of crisis that deviates from pre-crisis global integration trends. The results also lend credence to the wake-up call concept, since higher contagion is correlated with weaker macroeconomic fundamentals, which may indicate that investors reevaluated their risks during the crisis (Chittedi, 2015). These findings highlight the intricate interactions between macroeconomic, policy, and financial variables and jointly advance our knowledge of how financial crises spread throughout international markets.
Figure 1: Distribution of contagion coefficients
The study's Figure 1 demonstrates the substantial variation in how various portfolios handled the crisis. A broad trend of positive contagion indicated that portfolios tended to move in tandem during the crisis, but other portfolios showed a noteworthy ability to largely decouple from changes in the domestic, U.S., or global equity markets. This positive contagion tendency was especially noticeable in the context of home markets, which is consistent with the previously published parameter estimates. This suggests that internal factors within nations had a significant impact on portfolio performances during the crisis period.
The research findings indicate that measures taken by the government to protect the domestic banking industry, like enacting debt and deposit guarantees and providing capital to regional banks, were successful in reducing the spread of the virus, especially in the context of domestic markets. These measures were essential in shielding the national economy from the unrest in the banking industry. Furthermore, the study discovered that higher levels of external exposure through commerce and financial ties generally increased the interdependence of equity portfolios with both domestic and international markets. The study's finding that increased banking exposures exacerbated local contagion casts doubt on several conventional theories about the mitigating benefits of globalisation. The cascading impacts of vulnerabilities in the banking sector are highlighted, indicating that rather than serving as a means of diversification, interconnected banking systems may act as conduits for risk transmission during times of crisis.
The study's finding that increased banking exposures exacerbated local contagion casts doubt on several conventional theories about the mitigating benefits of globalisation. The cascading impacts of vulnerabilities in the banking sector are highlighted, indicating that rather than serving as a means of diversification, interconnected banking systems may act as conduits for risk transmission during times of crisis. The literature on crisis management, which emphasises the significance of state interventions in stabilising markets, is consistent with the effectiveness of government initiatives in reducing contagion. As seen by the actions of governments and central banks during the COVID-19 epidemic, reinforces the idea that proactive policy measures are essential during times of crisis.
A comparison of Bekaert et al.'s results with those of other studies reveals certain similarities and differences. For example, research on the transmission of financial crises by Kaminsky and Reinhart (2000) also highlights the importance of cross-border banking ties and common creditors, which resonates with the focus on banking exposure by researchers. However, this study's finding that more risk aversion during the crisis led to greater market segmentation is rather rare, providing new insight into investor behaviour during turbulent times (Morales and Andreosso-O'callaghan, 2010). Comprehending the mechanisms of contagion is essential for financial professionals, particularly those involved in risk management and portfolio construction. The study's conclusions can help develop crisis-resilient portfolio-building techniques by highlighting the importance of taking into account not only asset diversity but also the underlying financial and economic relationships. These insights can be used by policymakers to create crisis response plans that are more successful. Future policy decisions in crises similar to this one can be informed by knowledge about how government interventions can reduce contagion. These data can be used by investment advisors to inform their clients about the intricacies of interdependencies among global markets (Morales and Andreosso-O'callaghan, 2010). This information is essential for developing investing strategies that consider potential contagion risks and for establishing reasonable expectations.
The world financial scene has grown more intertwined in recent years. Globalisation and concentration in the financial sector, which includes a wide range of organisations such as commercial banks, investment banks, and hedge funds, have increased dramatically (Chittedi, 2015). These organisations now interact more closely; for instance, commercial and investment banks frequently lend money to one another, establishing direct connections. These institutions also frequently invest in comparable assets, which further indirectly integrates their activities. Regulatory reforms, most notably the US repeal of the Glass-Steagall Act in 1999, have expedited the blurring of boundaries between various financial institution types. At first, this act required that commercial and investment banking operations be kept apart. Following its repeal, there was a possibility that these activities may take place inside the same organisation, resulting in financial institutions that were bigger, more intricate, and more linked.
The idea of contagion effects in financial markets appears to have little evidence, according to this succinct assessment of the literature (Chittedi, 2015). Moreover, much of the literature suggests that rising economies are the main target of contagion. But this viewpoint stands in sharp contrast to recent advancements. This disparity draws attention to the shortcomings in the current definitions of contagion that have been applied in these investigations. The definitions that in place now seem ambiguous and leave out important factors that are required to build a more precise and thorough understand of financial market contagion.
Conclusion
It can be concluded that several crucial findings and significant problems regarding the interconnection of the global financial system are raised by the extensive study on the nature and dynamics of financial market contagion, especially in light of the global financial crisis of 2007–2009. The study sheds light on how complicated and multifaceted financial contagion is. The results cast doubt on several long-held assumptions, most notably the idea that emerging markets are the main victims of contagion. The study shows that contagion is a widespread occurrence that has significant effects even in established economies. This emphasises the necessity of a more comprehensive comprehension of contagion that transcends categorizations based on geography or developmental stage.
The study also highlights the gaps in our knowledge and definition of contagion at this time. The results imply that the conventional definitions are overly general and neglect to take into consideration important factors that are essential for a thorough comprehension of contagion dynamics. This means that the contagion idea in financial literature needs to be reexamined and improved. The complicated interplay of many causes during a crisis is highlighted by the variation in contagion and interdependence across different portfolios. This heterogeneity implies that understanding financial contagion necessitates taking into account particular regional, sectoral, and institutional settings and cannot be achieved through a one-size-fits-all approach.
References
Bekaert, G., Ehrmann, M., Fratzscher, M. and Mehl, A., 2014. The global crisis and equity market contagion. The Journal of Finance, 69(6), pp.2597-2649.
Chittedi, K.R. (2015). Financial Crisis and Contagion Effects to Indian Stock Market: ‘DCC–GARCH’ Analysis. Global Business Review, 16(1), pp.50–60. doi:https://doi.org/10.1177/0972150914553507.
Kaminsky, G.L. and Reinhart, C.M., 2000. On crises, contagion, and confusion. Journal of international Economics, 51(1), pp.145-168.
Morales, L. and Andreosso-O'callaghan, B. (2010). The Global Financial Crisis: World Market or Regional Contagion The Global Financial Crisis: World Market or Regional Contagion Effects? Effects? [online] Available at: https://arrow.tudublin.ie/cgi/viewcontent.cgi?article=1013&context=buschaccon [Accessed 13 Nov. 2023].
Whited, T.M. and Wu, G., 2006. Financial constraints risk. The review of financial studies, 19(2), pp.531-559.
