Borrowing capacity, financial instability, and contagion

Research output: Contribution to journalArticle

Abstract

We use the case of the 2007 United States subprime mortgage crisis to investigate the impact of borrowing capacity limitations on financial instability and contagion. We divide an economy into agents that interact via flow of funds and express the financial instability level of each agent as a function of time derivatives of its wealth, cash inflows, and borrowing capacity. We show that among these factors, the borrowing capacity, which is determined by other economic constraints, has the largest impact on financial instability. It is suggested that borrowing capacity limitations could even cause contagion through feedback loop formed by flow of funds. We use historical time series of the integrated macroeconomic accounts of the United Stated from 1960 to 2017 to verify our conjecture by quantifying the financial instability levels of the agents under different levels of borrowing capacity and how they affect one another during the period of the subprime mortgage crisis. Finally, the constraints of data collecting practice outside the United States in assessing borrowing capacity is addressed, accompanied by partial, yet compatible, results of selected Eurozone countries.

Original languageEnglish
Article number1850060
JournalInternational Journal of Theoretical and Applied Finance
Volume22
Issue number1
DOIs
StatePublished - 1 Feb 2019

Keywords

  • Agent-based model
  • borrowing capacity
  • contagion
  • financial instability
  • flow of funds
  • systemic risk

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