Testing for East-West Contagion in the European Banking Sector During the Financial Crisis

Abstract

Large and growing international financial linkages between East and West have altered the nature of the stability risks faced by European banking systems, increasing susceptibility to contagion. This paper aims to identify potential risks of cross-border contagion using a sample of large Western and Eastern European banks. We assume that contagion risk is associated with extreme co-movements in a market-based measure of bank soundness, controlling for common underlying factors. We also find evidence that contagion risk across European banks heightened significantly during the recent crisis. Contagion among Western European banks with the highest market share in Eastern Europe and from this group to Eastern European banks shows the largest increase in our sample. We find also evidence of contagion spreading from Eastern European banks, but this effect seems to reflect a broader phenomenon of contagion from emerging markets to banks in advanced countries exposed to these markets. Finally, our findings offer only mixed evidence of the existence of a direct ownership channel in the transmission of contagion.

Keywords: banking contagion, distance to default, testing hypothesis, logit model

JEL Classification: C12, G15, G21