CONTAGION IN GLOBAL BANKING

Risk in Global Banking: Why Contagion Cannot Be Eliminated

Amirsaleh Azadinamin

Doctorate Program

February 20, 2012

Electronic copy available at: http://ssrn.com/abstract=2008174

CONTAGION IN GLOBAL BANKING Abstract This paper addresses contagion as the greatest threat to global banking and it bases the argument not just on theory but also on past historic events, namely the banking crisis that followed the great depression as well as the recent crisis of credit. Numerous risks in global banking industry have been minimized and controlled by regulations such as Basel accords; however, contagion remains as the only detrimental factor yet to be eliminated. Financial institutions are interconnected through the same markets and an adverse effect of one will influence all others who are to some extent dependent through the same markets. Contagion is not solely limited by the interconnectedness of banking activities, but it is also the fear that is contagious among banking clients after a failure of a given institution. The fear factor is contagious and it could derive banking clients to withdraw deposits, and hence will drain banks out of liquidity, which leads to disastrous consequences.

Electronic copy available at: http://ssrn.com/abstract=2008174

CONTAGION IN GLOBAL BANKING What We Learned from the Recent Crisis of Credit What could the study of infectious disease teach us about the 2008 financial crisis? Plenty (Power, 2011, p. 1). This may provide a clear analogy on how contagious the banking industry has become. The case of Lehman Brothers is only the latest case that has provided a vivid example on how an infected member can spread through the whole network and the web of connections and ultimately take down the vast majority of the system as a whole. The interconnections that exist among banking institutions make them all part of one unified system. Banks and their individual state of health are essential, and the lack of thereof will not only put the customers of that particular bank in jeopardy, but it is also contagious. In a report provided by the Chilean government named Global Commercial Banking Outlook (2012), it is mentioned that the biggest risk to global banking sector remains the European crisis, with the worst-case scenario of a euro bloc breakup looming large in the background, and places the health of the global banking sector at risk. The statement emphasizes on how contagious, interconnected, and dependent the whole system is, in which the failure of the European

banking will have a domino effect of the rest of the globe; and this is yet the biggest risk that the system faces. The boom-and-bust process may come across as a huge threat to the global banking. The process by itself is not a threat per se to global banking, but it is what follows through the channel of contagion. The contagious effect will only come after the bust. Formation of bubbles in any bank-related market, like the market of housing mortgage, will have a direct effect on banks, and it will spread to other banks. A Contagious System Contagion has been blamed before for the total system failure in the banking industry, as many analysts also blame the rapid failures of banks between 1930 to 1933 on contagion. In his

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paper Depression-Era Bank Failures, Walter (2005) opens the argument with a question. [D]o Depression-era bank failures imply the need for government-provided deposit insurance, or is there another explanation of the failures other than contagion and inherent fragility? (p. 39). He argues that the deposit insurance program was created, at least in part, to prevent unfounded bank failures caused by contagion. However, watching the recent crisis being unfolded after the failure of Leman Brothers, one may ask whether the risk of contagion has been eliminated with the creation of deposit insurance program. If a large portion of Depression-era banking failures were the result of a shakeout rather than contagion, an important argument for deposit insurance is undercut. Though the termination of bank failures and the creation of the FDIC in 1934 occurred simultaneously, implying that contagion must have been at work, other explanations are just as credible. First, deposit insurance augmented the profits of risky banks, protecting them from failure. Second, the creation of deposit insurance undercut a market process that caused supervisors to close troubled banks quickly (Walter, 2005, p. 40). He mentions analysts argument in blaming the contagion as the factor that contributed to growing number banking failures in early 1920s. Analysts often cite contagion as the main factor behind rapid failures between 1930 and 1933. But has the creation of the deposit insurance program really eliminated the contagion factor? Some may argue against that. If one has learned anything from the recent financial crisis and the failure of Lehman Brothers, it is that the failure of a huge financial institution can bring irreparable damage to the system as a whole. Bacon and Pichardo (2009) offer explanation in the contagion that was spread following the failure of Leman Brothers: When Lehman Brothers collapsed, they had about $60 billion in toxic bad debts, and had

CONTAGION IN GLOBAL BANKING assets of $639 billion against debts of $613 billion; making it the largest investment bank to collapse since the 1990s.When Lehman collapsed, it sent a rippling affect across the globe, exposing how interconnected international markets have become. One of the largest companies affected were AIG, who backed a majority of credit default swaps by Lehman Brothers. So, when Lehman collapsed, AIG and many other banks, firms and individuals felt the pain (p. 43). The statement offered by Bacon and Pichardo (2009) highlights two issues as well as the devastating consequences that followed. High leverage ratios and the interconnectedness of the system are the main issues here. Giannetti (2003) explains how easily this risk factor could be enhanced if not properly monitored by regulators, stating that in an open economy a banking system with close bank-firm relationships may be easily subject to contagious banking crisis because it is difficult to distinguish between crony capitalism and good main bank relationships. How Contagion Works Walter (2005) offers a vivid explanation and an example in how contagion can bring the whole system to its knees. After failure of a prominent bank followed by Governments failure to bail out the institution, much like the case of Lehman Brothers, depositors will suffer losses. Customers of other bank learn of the failure, believing that their own bank might suffer the fate

running to their banks and asking for cash repayments on their deposits. This will create a ripple effect as it fears all banking customers regarding losing their deposits. The contagion is not solely about institutions, but it is also about fear among banking customers. Having to answer the customers demands, banks may have to liquidate their assets knowing that most bank assets are typically tied in loans and securities. Having to sell huge amounts of securities and assets,

CONTAGION IN GLOBAL BANKING the prices will fall and the bank will farther suffer losses on sales. Farther more, because outsiders now have deep concerns and having difficulties determining the worth of bank loans, they will also be willing to buy only at a deep discount, a phenomenon known as selling at fire sale prices. As the cycle continues, runs of otherwise healthy banks could cause such banks to suffer losses large enough that they would be unable to meet all depositor demands, creating failures of the banks experiencing the runs. The process would become a cycle, spreading widely (p. 46). Friedman and Schwartz (1963) argue that in cases as such it is the contagion of fear that leads to banks illiquidity and the failure of otherwise healthy banks. Summer et al., (2006) mention that this failure can happen as a consequence of a domino effect and in two very different ways: Bank defaults may be driven by losses from market and credit risks (fundamental default). Bank defaults may, however, also be initiated by contagion as a consequence of other bank failures in the system (contagious default) (p. 1310). Both situations are of the interest for regulatory institutions and they must intervene to prevent these widespread defaults. Aharony and Swary (1983) also mention that bankruptcy of a single bank, especially a large bank, may cause the loss of public confidence in the banking system as a whole and in turn, is likely to set off runs on other banks. This, in turn, causes losses to banks and their shareholders and disrupts the monetary system and the general economic stability (p. 305). Recognizing the Contagious System Valuzis and Zidulina (2009) mention that besides conducting monetary policy and maintaining price stability in a country, ensuring the financial stability for the whole system is an important task for central banks. In general, the financial stability of a country and the systemic risk of its financial system are strongly dependent on global macroeconomic factors

CONTAGION IN GLOBAL BANKING and also are closely related to the default risk of each financial institution and the industrial sector (p. 105). The main task of central banks must be impeding the rise of systemic risk following a failure of any giant financial institution. They mention that contagion on interbank markets can occur in at least three types of situation: 1- When aggregate liquidity is insufficient. In this situation following a failure of a bank and lack of trust of customers and depositors, they would withdraw their deposits and banks would face a liquidity crisis and leads to losing the ability to meet liabilities. 2- When market expectations create spillover effects, in which the process will even affect those that are not directly involved. This could be exemplifies as where a bank failure would cause failures in insurance or mortgage markets. This type of contagion would cause damage to those institutions that are connected through their activities in the same market. 3- When the collapse of a bank induces a domino effect. This would take its toll on financial institutions that are closely interconnected. This point is also mentioned by Aharony and Swary (1983) as a contagion effect that is compared to the domino effect following a bank failure. [R]egardless of the cause of bank failure, its effect would spill over to other banks, too. This will be referred to as the pure contagion effect (p. 306). The crisis that is facing the Euro zone may be the biggest threat yet that facing not just the Eurozone, but the global banking industry. The extent of the contagion risk coming out of the biggest global economic zone will vastly shock the globally integrated financial system and will channel through all developing countries as well. Valuzis and Zidulina (2009) also address three questions to assess the risk of contagion:

CONTAGION IN GLOBAL BANKING 1- How strong and important is the actual interbank market structure for explaining interbank contagion risk? The biggest issue regarding this question is the lack of data.

Default events of credit institutions are quite rare and data collected over many years can hardly be a sample of stationary process and the reliable statistical estimates of distributional parameters are almost impossible to obtain. This will only add to the uncertainty of the extent of institutions involvement in a certain market. 2- Could the failure of banks, or even a single but huge financial institution in a given region, affect banks in the same or other regions? Regarding this question, one may ask whether the banks are the source of credit contagion of the victims of it. In case they are the source of the credit contagion, this will enhance the big banks strong dependence on the liquidity risk, which leads to the next question in line: 3- Could the liquidity shortage of a single bank, or some banks in a certain region, patronize banks in other regions? As it was mentioned previously, Giannetti (2003) argues about the source of contagion and how open banking with close bank-firm relationships may easily lead to contagious banking crisis. It may be difficult at times to distinguish between crony capitalism and good main bank relationships. Giannetti (2003) further argues that this may be a bigger phenomenon in developing countries where structured finance tools and issuing bonds by corporations are not as common, and external finance to firms is provided mainly by banks. Furthermore, bank-firm relationships are very close and borrowers usually rely on a single bank. This situation is usually condemned for causing problems of crony capitalism and connected lending because banks would have incentives to fund negative-net-present-value projects (p. 239). Most

CONTAGION IN GLOBAL BANKING importantly, this crony capitalism can be a main factor behind the process of accumulating bad loans, and ultimately a banking crisis. Concluding Remarks As Dasgupta (2004) puts it, [a] commonly held view of financial crises is that they begin locallyin some region, country, or institutionand subsequently spread elsewhere. This process of spread is often referred to as contagion (p. 1049). This contagion can happen in two ways. First, adverse information that starts a crisis could, and most likely would imply adverse information about other otherwise healthy financial institutions. This is what was mentioned previously as the fear contagion that is caused by the lack of confidence in the system. Secondly, these institutions are connected through direct portfolio or balance sheet connections and while such balance sheet connections may seem to be desirable ex ante, during a crisis the failure of one institution can have direct negative payoff effects upon stakeholders of institutions with which it is linked (p. 1050). Some critics believe that the absence of full-reserve banking and having high leverage ratios create the risk of failure, but many others believe the full-reserve banking as impractical. After federal deposit insurance program was created many came to believe that bankruptcies were the thing of the past and the chain reaction in bank failures of 1930s would not be seen again. However, the recent crisis that was triggered by the failure of Lehman Brothers showed that the risk of contagion was never eradicated in the first place. Regulators and guidelines have been able to eradicate numerous risky tools, instrument, and activities to place the banking industry and its customers over a safety net. Contagion may be the single factor they have not been able to eliminate and thus it may pose as the biggest threat to global banking. As Summers et al., (2006) mention, the correlation in banks asset portfolios dominates contagion as the main source of systematic risk.

CONTAGION IN GLOBAL BANKING Contagion is rare but can nonetheless wipe out a major part of the banking system (p. 1301). This may very well explain why a report provided by the Chilean government called Global Commercial Banking Outlook (2012) states that the current euro zone crisis remains the biggest concern and risk for the world economy: contagion.

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CONTAGION IN GLOBAL BANKING References Aharony, J., & Swary, I. (1983). Contagion Effects of Bank Failures: Evidence from Capital Markets. Journal Of Business, 56(3), 305-322. Dasgupta, A. (2004). Financial contagion through capital connections: A model of the origin

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and spread of bank panics. Journal Of The European Economic Association, 2(6), 10491084. doi:10.1162/1542476042813896 Global commercial banking outlook. (2012). Chile Commercial Banking Report, (1), 13-21. Friedman, Milton, and Anna Jacobson Schwartz. 1963. A monetary history of the United States, 18671960. Princeton: Princeton University Press (for the National Bureau of Economic Research). Pichardo, C., & Bacon, F. (2009). The Lehman Brothers bankruptcy: A test of market efficiency. Allied Academies International Conference: Proceedings Of The Academy Of Accounting & Financial Studies (AAFS), 14(1), 43-48. Power, C. (2011). Too contagious to fail. Scientific American, 304(4), 22. Walter, J. R. (2005). Depression-Era Bank Failures: The Great contagion or the great shakeout?. Economic Quarterly (10697225), 91(1), 39-54. Valuis, M. M., & iduina, T. T. (2009). Bank liquidity risk and its contagion effect in the Baltic financial sector. Scientific Proceedings Of RTU: Economics & Business, 18105115.