Spillovers from systemic bank defaults

Mark Mink, Jakob de Haan 24 May 2014

a

A

Financial-crisis management and prevention policies often focus on mitigating spillovers from the default of systemically important banks. During the recent crisis, governments avoided large bank failures by insuring and purchasing intermediaries’ troubled assets, by providing them with capital injections, and even by outright nationalisations. After the crisis, financial regulators designed additional requirements for those institutions that the Financial Stability Board designated as globally systemically important banks (G-SIBs).

Despite these policy efforts, and perhaps surprisingly, the unprecedented bailout decisions during the crisis were neither based on a clear understanding of the magnitude of potential spillovers from bank failures, nor on a clear notion of which banks are systemically important. Consider, for instance, the US government’s decision to provide asset guarantees and additional capital to Citigroup in November 2008. As reported by the Office of the Inspector General, responsible for supervising and auditing the operations of the US Federal Government, the premise underlying this intervention was that Citigroup was too systemically important to be permitted to collapse. Although Citigroup was the second-largest bank in the US, the Office concludes that there was surprisingly little information available on the nature and magnitude of any spillover effects its failure could bring about: “the conclusion of the various government actors that Citigroup had to be saved was strikingly ad hoc. While there was consensus that Citigroup was too systemically significant to be allowed to fail, that consensus appeared to be based as much on gut instinct and fear of the unknown as on objective criteria. As Treasury Secretary Paulson stated on one of the conference calls preceding the rescue, ‘If Citi isn’t systemic, I don’t know what is’.” (SIGTARP 2011: 42).

Measuring spillovers from G-SIBs

To improve our understanding of spillovers from the default of a systemic bank, in Mink and De Haan (2014) we analyse for the 2007–2012 period whether changes in the default risk of globally systemically important banks affect the stock market values of other banks.1 If financial markets expect a G-SIB’s default to cause losses for other banks, any increase in a G-SIB’s default probability should lead to a decline in other banks’ market values. This relationship holds irrespective of the precise spillover channel that is at work, and takes into account that also the anticipation of a G-SIB’s potential default can cause spillovers to other banks. Typical event studies that examine the impact of large bank defaults cannot allow for such anticipation effects and, due to the rarity of default events, have either a smaller or a less homogeneous sample available for their analysis.

Our regression analysis suggests that the market values of banks in the US and the EU hardly respond to changes in individual G-SIBs’ default risk. This result is in line with that of Helwege and Zhang (2013), who show that spillovers from financial firm bankruptcies are modest due to, for instance, diversification regulations.2 Despite their small individual impact, however, we find that changes in all G-SIBs’ default risk explain a substantial part of changes in bank market values. G-SIBs thus seem systemically important as a group. In addition, we find that banks’ exposure to common shocks causes their market values to be highly correlated amongst each other, which Wagner (2010) explains is a source of systemic risk as well. Finally, we show that our results are robust for analysing various sub-samples and for using both credit default swap spreads and Moody’s expected default frequencies as indicators of G-SIBs’ default risk.

Concluding remarks

Our results do not imply that during the crisis individual G-SIBs could have been allowed to go bankrupt without consequences for the stability of the financial system. While spillovers caused by such failures may be smaller than feared, financial market participants generally assumed that governments would stand ready to rescue any failing G-SIBs. Suddenly reverting such a policy would act as an adverse common shock driving up investors’ assessment of default risk for the G-SIBs as a group. Our results show that such a joint increase in G-SIBs’ default risk would depress other banks’ market values. Dynamics such as these are likely to have played an important role after the Lehman Brothers collapse in September 2008.

While bailing out individual G-SIBs during the recent crisis may thus have been inevitable, our finding that spillovers from individual G-SIBs are relatively limited suggests that governments should in the future be able to commit more credibly to not bailing out individual G-SIBs. The actual failure of a G-SIB would then be less of a shock to financial markets. Our results also imply that future declines in bank market values may be mitigated by increasing the resilience of banks to spillovers from G-SIBs as a group and to adverse common shocks.

Disclaimer: The views expressed in this column are those of the authors and do not necessarily reflect official positions of De Nederlandsche Bank (DNB).

References

De Bandt, O, P Hartmann, and J Peydró (2010), “Systemic risk in banking: an update”, in M Berger and J Wilson (eds.), The Oxford Handbook of Banking, Oxford: Oxford University Press: 633–672.

Helwege, J and G Zhang (2013), “Financial firm bankruptcy and contagion”, unpublished manuscript.

Kaufman, G (1994), “Bank contagion: a review of theory and evidence”, Journal of Financial Services Research, 8: 123–150.

Mink, M (2010), “Do financial markets expect bank defaults to be contagious?”, DNB Working Paper 274.

Mink, M and J De Haan (2014), “Spillovers from systemic bank defaults”, CESifo Working Paper 4792.

Wagner, W (2010), Diversification at financial institutions and systemic crises, Journal of Financial Intermediation, 19: 373–386.

Special Inspector General for the Troubled Asset Relief Program (2011), “Extraordinary financial assistance provided to Citigroup, Inc.”, Office of the Special Inspector General, Washington DC.


1Our analysis is based on previous work by Mink (2010).

2 Our results are also in line with the views of Kaufman (1994), who argues that the academic literature provides “no evidence to support the widely held belief that, even in the absence of deposit insurance, bank contagion is a holocaust that can bring down solvent banks, the financial system, and even the entire macroeconomy in domino fashion.” More recently, also De Bandt, Hartmann, and Peydró (2010: 664) concluded that “the practical and unambiguous identification of concrete contagion cases continues to be a challenge.”
 

a

A

Topics:  Financial markets

Tags:  financial stability, spillovers, regulation, banking, banks, systemic risk