Contagion Effect - Policy Implications

Policy Implications

See also: Financial regulation See also: Wall Street reform

Financial contagion is one of the main causes of financial regulation. How to make domestic financial regulation and plan the international financial architecture to prevent financial contagion become the top priority for both domestic financial regulators and international society, say, G-20 summit, especially when the global economy are being under challenge from the US Subprime mortgage crisis and European sovereign debt crisis.

At international level, under today's modern financial systems, a complicated web of claims and obligations link the balance sheets of a wide variety of intermediaries, such as hedge funds and banks, into a global financial network. The development of sophisticated financial products, such as credit default swaps and collateralized debt obligations, has complicated the financial regulation. As has been shown by the US financial recession, the trigger of failure of Lehman Brothers dramatically spread the shock to whole financial system and other financial markets. Therefore, understanding the reasons and mechanisms of international financial contagion can help policy makers improve the global financial regulation system and thus make it more resistant to shocks and contagions.

At domestic level, financial fragility is always associated with a short maturity of outstanding debt as well as contingent public liabilities. Therefore, a better domestic financial regulation structure can improve an economy’s liquidity and limit its exposure to contagion. A better understanding of financial contagion between financial intermediaries, including banking, rating agencies and hedge fund will be conducive to making financial reform in both US and European Countries, say how to set up the capital ratio to jungle the balance between maximizing banks' profit and shielding them from shocks and contagions.