The contagious effect:
A) stems from the positive correlation in FI returns.
B) results when interest rate risk increases credit risk and liquidity risk exposures.
C) occurs when liquidity risk problems at bad banks damages well-run banks.
D) is completely eliminated by government provided deposit insurance against bank runs.

Question

Quizplus · Accepted Answer

The contagious effect refers to the situation where liquidity risk problems at bad banks damage well-run banks, leading to a broader financial crisis. This was seen during the 2008 financial crisis, where the failure of some banks led to a loss of confidence in the entire financial system. Thus, option C is the correct choice. Option A is incorrect as the positive correlation in FI returns does not directly relate to the contagious effect. Option B is incorrect as interest rate risk, credit risk, and liquidity risk are distinct risks that can impact a financial institution, but the question is specifically referring to the contagious effect. Option D is incorrect as deposit insurance can help in mitigating the impact of bank runs, but it does not completely eliminate the contagious effect.

The Contagious Effect