How Does Failure Spread Across Broker-Dealers and Dealer Banks?

Abstract

We empirically test for the presence of two types of financial contagion across large broker-dealers and dealer banks during the crisis of 2007-2009: the type based on the idea that market illiquidity mediates the spread of distress from one dealer to others, or, “liquidity contagion”, and the type based on the idea that one dealer’s distress directly undermines the franchise value of others, or, “franchise value contagion”. We test for the two types of contagion against the null hypothesis that correlation in dealer-distress during the crisis was only due to an observable common shock to the real estate assets that triggered the crisis. We find evidence that prior to the Federal Reserve and Treasury market interventions in the Fall of 2008, both types of contagion were present. Franchise-value contagion, however, dominates, accounting for 95% of all contagion. Furthermore, unlike liquidity contagion which disappears after the interventions are in place, franchise-value contagion remains.