Because of asymmetric information, the failure of one bank can lead to runs on other banks. This is the:

Question

BlackTom AI · Accepted Answer

Contagion occurs when the failure of one financial institution leads depositors or investors to lose confidence in other institutions, triggering runs or withdrawals elsewhere.

1. Relevant knowledge points and concepts
- Asymmetric information: depositors cannot perfectly observe banks’ true solvency, so bad news about one bank raises uncertainty about others.
- Bank run: rapid withdrawals by depositors fearing loss.
- Contagion effect: loss of confidence spreads across institutions, causing otherwise healthy banks to face runs.
- Adverse selection and moral hazard: different information problems in markets; too-big-to-fail: policy expectation of government rescue.

2. Step-by-step reasoning
- Suppose Bank A fails or appears distressed. Public learns of A’s problems.
- Because depositors face asymmetric information about other banks’ asset quality, they cannot easily distinguish which banks are safe.
- This uncertainty induces precautionary withdrawals from Bank B and C, even if those banks are solvent.
- These withdrawals can force funding shortfalls and asset fire sales, potentially causing additional failures.
- This propagation of distress from one bank to others is precisely contagion.

3. Intermediate logical steps (no numeric calculation needed)
- Information gap → perceived common vulnerability → withdrawal behavior increases → liquidity stress at other banks → potential runs and failures.

4. Why the correct answer is correct
- The phenomenon described—failure of one bank leading to runs on others because of asymmetric information—is the textbook definition of the contagion effect. Contagion emphasizes spread of panic or loss of confidence across institutions.

5. Why the other options are incorrect
- a. Adverse selection problem: refers to high-risk participants being more likely to engage in a transaction before contracting, not the spread of bank runs.
- c. Too-big-to-fail effect: describes expectation of government bailouts for large institutions, not the domino runs caused by asymmetric information.
- d. Moral hazard problem: concerns changes in behavior once protected (e.g., by insurance), not initial cross-bank panic spread.

6. Conclusion
This reasoning confirms the correct answer is b. contagion effect, matching the provided answer.

Because of asymmetric information, the failure of one bank can lead to runs on other banks. This is the:Single choice

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