Let a small bank fail : Implicit non-guarantee and financial contagion
Liu, Liyuan; Wang, Xianshuang; Zhou, Zhen (18.10.2024)
Numero
11/2024Julkaisija
Bank of Finland
2024
Julkaisun pysyvä osoite on
https://urn.fi/URN:NBN:fi-fe2024101882357Tiivistelmä
This paper examines the consequences of Chinese regulators deviating from a long-standing full bailout policy in addressing the distress of a city-level commercial bank. This policy shift led to a persistent widening of credit spreads and a significant decline in funding ratios for negotiable certificates of deposit issued by small banks relative to large ones. Our empirical analysis reveals a novel contagion mechanism driven by reduced confidence in future bailouts (implicit non-guarantee), contributing to the subsequent collapse of other small banks. However, in the longer term, this policy shift improved price efficiency, credit allocation, and discouraged risk-taking among small banks.
Julkaisuhuomautus
NON-TECHNICAL SUMMARY
FOCUS
The classical theory explaining implicit guarantee, the "too big to fail" (TBTF) doctrine, suggests that large bank failures can trigger systemic crises through balance sheet contagion or fire sales. However, it overlooks the frequent bailouts of smaller banks, as seen in the U.S. regulators’ recent decision to extend full deposit insurance to Silicon Valley Bank and Signature Bank. This paper explores an unexpected bailout policy shift—from a full bailout to a partial bailout—following a small bank’s collapse in China. The study is to examine the impacts of this policy shift and the resulting belief change about the future government bailout (or implicit non-guarantee), with a focus on the interbank market.
CONTRIBUTION
This paper contributes to the literature in three ways. First, it highlight a novel contagion mechanism where a small bank’s failure, triggered by a bailout policy shift, can spread to other small banks through implicit non-guarantee, independent of direct financial connections or traditional contagion channels, as well as indirect contagion from fire sales and common asset ownership. Second, it adds to the literature on implicit government guarantees by providing empirical evidence on how reduced bailout expectations affect market efficiency, financial stability, and banks’ behavior, particularly for small banks. Finally, the study enhances the understanding of implicit guarantees and bailouts in China’s banking sector by examining their systemic and persistent impact on risk and efficiency.
FINDINGS
The main empirical finding reveals that departing from the full bailout policy for small banks resulted in a significant deterioration of funding conditions and subsequent failures of several other small banks in the negotiable certificates of deposit (NCDs) market. Specifically, systemically unimportant (SU) banks, relative to systemically important (SI) ones, experience a significant increase in the cost of borrowing through the issuance of NCDs. Despite this pricing effect, the amount of funding SU banks can secure in the NCD market is significantly lower following the policy change. Furthermore, we provide additional supportive evidence that the spillover is caused by implicit non-guarantee. This paper also indicates that reducing the market confidence in government bailout will improve price efficiency and credit allocation, mitigate moral hazard, and prevent banks from taking excessive risks.
FOCUS
The classical theory explaining implicit guarantee, the "too big to fail" (TBTF) doctrine, suggests that large bank failures can trigger systemic crises through balance sheet contagion or fire sales. However, it overlooks the frequent bailouts of smaller banks, as seen in the U.S. regulators’ recent decision to extend full deposit insurance to Silicon Valley Bank and Signature Bank. This paper explores an unexpected bailout policy shift—from a full bailout to a partial bailout—following a small bank’s collapse in China. The study is to examine the impacts of this policy shift and the resulting belief change about the future government bailout (or implicit non-guarantee), with a focus on the interbank market.
CONTRIBUTION
This paper contributes to the literature in three ways. First, it highlight a novel contagion mechanism where a small bank’s failure, triggered by a bailout policy shift, can spread to other small banks through implicit non-guarantee, independent of direct financial connections or traditional contagion channels, as well as indirect contagion from fire sales and common asset ownership. Second, it adds to the literature on implicit government guarantees by providing empirical evidence on how reduced bailout expectations affect market efficiency, financial stability, and banks’ behavior, particularly for small banks. Finally, the study enhances the understanding of implicit guarantees and bailouts in China’s banking sector by examining their systemic and persistent impact on risk and efficiency.
FINDINGS
The main empirical finding reveals that departing from the full bailout policy for small banks resulted in a significant deterioration of funding conditions and subsequent failures of several other small banks in the negotiable certificates of deposit (NCDs) market. Specifically, systemically unimportant (SU) banks, relative to systemically important (SI) ones, experience a significant increase in the cost of borrowing through the issuance of NCDs. Despite this pricing effect, the amount of funding SU banks can secure in the NCD market is significantly lower following the policy change. Furthermore, we provide additional supportive evidence that the spillover is caused by implicit non-guarantee. This paper also indicates that reducing the market confidence in government bailout will improve price efficiency and credit allocation, mitigate moral hazard, and prevent banks from taking excessive risks.