Why do contagion effects vary among bank failures

Abstract Many of the previous studies on contagion effects in the banking industry focused on the failure of a large bank to determine whether the adverse effects spread to other banks. Yet, little is known whether other publicized bank failures cause contagion effects, and why the effects may vary among bank failures. Given the changes in the banking environment over time, contagion effects could be conditioned on the characteristics of the failing bank and of the banking environment at that time. We assess 99 publicized bank failures over the 1980–1996 period, and find that contagion effects exist in general for the surviving rivals of the failed bank. The degree of contagion effects varies over time (among bank failures), and is stronger when the failed bank is a multibank holding company, when the failed bank is publicly held, when the failed bank is relatively large, when the rivals are relatively small, and when the rivals have relatively low capital levels. The contagion effects are less pronounced in the period following the passage of FIRREA. Furthermore, the total risk-shifts of surviving rival banks in response to the announcement of a failed bank are inversely related to their capital level, and total risk-shifts of rival banks are less pronounced for failures occurring just after the passage of FIRREA. The results suggest that a bank’s exposure to possible contagion effects due to a bank failure can be partially controlled by a bank’s managerial policies and by regulatory policies.