Reputational Contagion and Optimal Regulatory Forbearance
Harvard Business School - Finance Unit; Centre for Economic Policy Research (CEPR)
Alan D. Morrison
University of Oxford - Said Business School; University of Oxford - Merton College
May 10, 2010
ECB Working Paper No. 1196
This paper examines common regulation as cause of interbank contagion. Studies based on the correlation of bank assets and the extent of interbank lending may underestimate the likelihood of contagion because they do not incorporate the fact that banks have a common regulator. In our model, the failure of one bank can undermine the public’s confidence in the competence of the banking regulator, and hence in other banks chartered by the same regulator. Thus depositors may withdraw funds from other, unconnected, banks. The optimal regulatory response to this "panic" behaviour can be to privately exhibit forbearance to the initially failing bank in the hope that it - and hence other vulnerable banks - survives. By contrast, public bailouts are ineffective in preventing panics and must be bolstered by other measures such as increased deposit insurance coverage. Regulatory transparency improves confidence ex ante but impedes regulators’ ability to stem panics ex post.
Number of Pages in PDF File: 34
Keywords: Contagion, Reputation, Bank Regulation
JEL Classification: G21, G28working papers series
Date posted: May 25, 2010
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