“Death spiral”, contagion and systemic risk

Banks are required to maintain “adequate capital” to comply with regulatory requirements. The capital ratio is the percentage of bank’s capital to its risk-weighted assets. Weights are defined by Basel Accords. Adequately capitalized banks are required to have a no lower than 4% Tier 1 capital ratio and a no lower than 8% total capital ratio.

At the beginning of the crisis, the values of mortgage-backed assets started to fall, and firms holding mortgage-backed assets had to write those assets down to market value, the bank’s regulatory capital went down. Under certain loan covenants and regulatory capital requirements, banks were forced to sell mortgage-backed assets for cash to reduce “risk adjusted assets”. Some firms were also selling because of a fear that the prices will decline further. The fire sale created an excessive supply which further drove down the market price of mortgage-backed assets and the regulatory capital of banks continued to decline. This phenomenon is referred to as the “death spiral”.

Moreover, death spiral can lead to “financial contagion”. If fire-sale prices from a distressed bank become relevant marks for other banks, mark-to-market accounting can cause write-downs and regulatory capital problems for otherwise sound banks (Cifuentes, Ferrucci, and Shin, 2005; Allen and Carletti, 2008; Heaton, Lucas, and McDonald, 2009). This is considered to be systemic risk in the banking industry.