The Shocks in the Interbank Market: An Analysis of China and the US

• Author: Li Zeng,Ziwei Fei,Xiaoquan Jiang,Jiangang Peng
• Published date: 01 December 2015
• Date: 01 December 2015
• DOI: http://doi.org/10.1111/ajfs.12116

The Shocks in the Interbank Market: An

Analysis of China and the US*

Ziwei Fei

College of Finance and Statistics, Hunan University

Xiaoquan Jiang

College of Business, Florida International University

Li Zeng

College of Finance and Statistics, Hunan University

Jiangang Peng**

College of Finance and Statistics, Hunan University

Received 19 May 2014; Accepted 20 September 2015

Abstract

We compare the contagion risk in the interbank market between China and the United States

during the period from 2011 to 2013. Applying simulation method, we find that the conta-

gion risk of an individual bank shock in the US interbank market is relatively lower than that

in China during the period. For a group bank shock, we find that the group with the lowest

capital adequacy ratio in China induces a serious contagion, while the group with the highest

concentration degree in the US induces a mild contagion. One potential reason is that the

additional capital of most commercial banks in China is relatively lower than that of the US

and most banks in China highly depend on the interbank market for acquiring liquidity or

income.

Keywords Basel III; Capital adequacy ratio; Concentration degree; Contagion risk; Interbank

market

JEL Classification: G18, G21, G33

*We appreciate the Editor, the Associate Editor, and two anonymous referees for their valu-

able comments and suggestions. The study was supported by the National Natural Science

Foundation of China (No. 71373071 and No. 71073048). This paper was communicated at

the 2014 annual meeting of China’s financial engineering in Shanghai Normal University,

and won the third prize.

**Corresponding author: Jiangang Peng, College of Finance and Statistics, Hunan University,

Changsha, Hunan Province, 410079, P. R. China. Tel: +86-13808418642, Fax: +86

73188684836, email: pengjiangang@139.com.

Asia-Pacific Journal of Financial Studies (2016) 44, 877–898 doi:10.1111/ajfs.12116

©2015 Korean Securities Association 877

1. Introduction

Systemic risk is a risk of disruptions in the provision of key financial services that

can induce serious consequences for a real economy (IMF, 2009). It is an extreme

risk. The recent global financial crisis had a huge impact on financial systems and

the real economy. During the crisis, there were bank failures in the United States,

European Union, and elsewhere. Countries like Iceland and Greece even faced the

threat of state bankruptcy. The assessment and disposal of contagion risk has

become a hot topic among regulators, such as the Basel Committee on Banking

Supervision (BCBS), Financial Stability Board (FSB), World Bank, International

Monetary Fund (IMF), as well as academics and practitioners.

The interbank market is viewed as an important channel through which the dis-

tress of one bank can spread to other banks, and then to the financial system quickly

(Adrian and Shin, 2008; Memmel et al., 2012; Tiana et al., 2013). Interbank contagion

is likely to result in systemic risk. The contagion effect also looks like a dominant

effect, where the failure of a bank results in the failure of other banks even if the latter

are not directly affected by the initial shock (Upper and Worms, 2004).

As contagion risk stands out in the financial market since the latest financial cri-

sis, we try to understand how it spreads among the financial institutions in and out

of a country. We also look for ways to reduce the probability of contagion and

losses of contagion, in order to prevent banks from systemic risk.

Our paper follows the framework of Basel III (released in 2010). After the recent

global financial crisis, many countries issued new regulations according to the Basel III

because it aims to guard against systemic risk. Interbank market is a major transaction

place for the banking sector and is a very important contagion channel of systemic risk.

The US is the largest economy with the most developed financial market in the world

while China is the second largest economy with less developed financial market. There

are significant differences in infrastructure of financial markets, banking systems, the

degree of government interference, etc. It is interesting to compare the contagion risk

in the interbank market between China and the US. We hope our evidence sheds addi-

tional light on the contagion in the interbank market in the two countries.

We compare the structure and bank’s characteristics in the interbank markets

between China and the US during the period from 2011 to 2013, after the publica-

tion of Basel III. We examine and compare the contagion risk in the two countries

using a simulation of 150 largest commercial banks in China and the US. We

assume the liquidity shock comes from an individual bank each time. We set LGD

(loss given default) as a control variable.

We adopt a criterion of contagion by adjusting the formula of capital adequacy

ratio (CAR) which is put forth in Basel III. We set the threshold value of contagion

as 8%. This formula can easily capture the risk of contagion without the assump-

tion that a bank is bankrupt or insolvent.

After Basel III released, many countries in the world began and contin ue to

implement the corresponding new regulatory policy actively, which aims to improve

Z. Fei et al.

878 ©2015 Korean Securities Association