On the Contagion Effect in the US Banking Sector

• Published date: 01 February 2019
• Author: GABRIEL PINO,SUBHASH C. SHARMA
• Date: 01 February 2019
• DOI: http://doi.org/10.1111/jmcb.12489

DOI: 10.1111/jmcb.12489

GABRIEL PINO

SUBHASH C. SHARMA

On the Contagion Effect in the US Banking Sector

By using the spatial econometrics methodology, this paper investigates the

contagion of the risk taking by banks in the US banking sector during 2001

to 2012. In addition, the contagion signals up to the Subprime crisis in

2008 are analyzed and different channels of contagion are studied in order

to identify fragile groups of banks. Our analysis reveals that there is no

significant contagion transmitted to the whole banking system. However,

we observe that the bank contagion is significantly spread locally and for

the group of banks that share similar characteristics related to size and bank

regulations.

JEL codes: E5, E44, G21

Keywords: bank contagion, bank stability, spatial econometrics, subprime

crisis.

THE BANKING SECTOR IS VITAL for the economy because it fa-

cilitates investment and consumption which are central to the health of the economy.

Nevertheless, the banking sector is highly fragile due to systemic risk in the banking

sector as compared to firms in the other sectors of the economy (see, e.g., Allen and

Gale 2006, Reinhart and Rogoff 2009, and Acharya et al., 2010 for a discussion of its

main causes). In this environment, bank contagion can intensify the systemic risk and

the probability of a banking crisis. Interbank credits and portfolio connections are the

two main links by which banks transmit risk to one another. For instance, Cifuentes,

Ferrucci, and Shin (2005), Allen and Carletti (2006), and Boyson, Stahel, and Stulz

(2008) have noted that a failure or disruption in one bank will affect the profits of

other banks. A number of authors, for example, Allen and Gale (2000) and Babus

(2007) perceive that bank connections are desirable since the stability of the banking

We would liketo thank the referee for valuable comments which has greatly improved this paper.

GABRIEL PINO is an Assistant Professor, Facultad de Econom´

ıa y Negocios, Universidad de Talca.

(E-mail: gpino@utalca.cl) SUBHASH C. SHARMA is a Professor, Department of Economics, Southern

Illinois University Carbondale (E-mail: sharma@siu.edu).

Received January 22, 2015; and accepted in revised form October 4, 2017.

Journal of Money, Credit and Banking, Vol. 51, No. 1 (February 2019)

C

2018 The Ohio State University

262 :MONEY,CREDIT AND BANKING

sector can increase when bank risk is shared by a large number of banks. However,

in the presence of asymmetric information (Nicolo and Pelizzon 2004, and Morrison

and White 2005) and poor regulations (Allen and Gale 2006), diversification may

enhance bank contagion, increasing the fragility of the banking sector (Dasgupta

2004, Brusco and Castiglionesi 2007). Therefore, in order to preserve the stability

of the banking sector it is important to measure and track the bank contagion over

time.

To study the bank contagion empirically, it is necessary to have a proper measure

of risk and also an efficient approach to capture the contagion of the risk taking of

banks. Because of these factors, the empirical evidence about the bank contagion is

not extensive and is mainly focused on the transmission effect captured through the

stock prices of banks. Although some authors argue that the bank contagion arises for

banks with poor performance (e.g., Aharony and Swary 1983, Swary 1986, Aharony

and Swary 1996, Akhigbe and Madura 2001), others report evidence that the bank

contagion can be transmitted to the whole banking sector (e.g., Madura and Tucker

1991, and Jayanti, Whyte, and Do 1996). Some other researchers focus on the root

of the bank contagion, that is, specific or general economic root (Cornett, McNutt,

and Tehranian 2005), international bank contagion (Kanas 2005) or the behavior of

the clients of a specific bank (Iyer and Puri 2012).

The objective of this paper is to identify the channels of bank contagion that can be

useful to preserve the stability of the US banking sector. We contribute to the banking

literature in three ways. First, we focus on the contagion of the risk taking of banks.

This is relevant given that we are able to capture how an increase in the risk taking

of a specific bank affects other banks. By contrast, most of the existing literature

focuses on how a bank failure is spread to other banks by analyzing the abnormal

returns of their stock prices. Second, we use the spatial econometrics methodology

which allows us to capture and measure the impact of the risk taking among banks

that belongs to the same neighborhood. Thus, we provide an efficient tool to track the

evolution of the contagion of the risk taking overtime. Finally, we investigate whether

the bank contagion spread among banks that share similar characteristics, or whether

the spread was geographical (i.e., nationwide or local). The characteristics studied

here are the banks that have similar regulations and the banks that are of same size.

Geographical contagion is approached by analyzing whether the risk taking of banks

is transmitted to all banks in the US banking sector (i.e., nationwide contagion), or

whether this is only transmitted to banks that belong to the same state (i.e., local

contagion).

Our analysis reveals that there is no contagion when the change in the risk taking

of a specific bank is assumed to affect all other banks in the US banking sector.

Nevertheless, a significant contagion effect is identified for banks that belong to the

same state, the same Federal-Reserve district, and banks that are of the same size. In

particular, we observe a significant bank contagion since 2003 which intensified in

2006 prior to the Subprime crisis in 2008 and continued to persist till the last period

in our analysis, that is, 2012. Among the three channels of contagion analyzed here,

banks that belong to the same state, that is, local contagion, should be the focus group