PRINCIPLES OF INTERMEDIATION

Principles of Intermediation

Principles of Intermediation

Introduction

How important are financial linkages in transmitting shocks across the financial system? How vulnerable is the financial system to contagion due to its high-degree of financial connections? What are the factors that mitigate the extent of contagion? From a policy perspective, understanding these questions is critical. The design measures of macro-prudential regulation and supervision - in particular policies related to crisis management and ex-ante safety nets - depends on it (see Olivier et al. 2009 andLeijonhufvud 2009).

Article Summary: Iyer, Rajkamal, and Jose-Luis Peydro. 2010. Interbank contagion at work: evidence from a natural experiment. European Central Bank, Working Paper Series: 1147.

The current global financial crisis has once again highlighted the risks posed by interbank markets. One of the main motivations for regulators in bailing out large banks and other large financial institutions was the fear of propagation of the crisis due to the high financial connections. However, the question that remains unanswered is how significant are these risks and how the risks vary depending on the fundamentals of the banking system.

The major challenges in identifying financial contagion due to interbank linkages are:

* the lack of detailed data on interbank linkages during a crisis time,

* the dearth of large-bank failures, which implies a lack of events for empirical studies1, and

* often - as in the current crisis - the failure of a bank is not exogenous to the general economic conditions, making it difficult to disentangle the contagion effects from its sources.

In a forthcoming paper (Rajkamal et al. 2010b) we overcome these hurdles by exploiting an event of sudden failure of a large cooperative bank in India - the bank failed due to fraud and was not bailed out (there was no other fraud in other banks and the economy was performing well). This event is documented by a unique dataset that allows us to identify interbank exposures at the time of the bank failure. This provides us with an ideal platform - a natural experiment - to test the hypothesis of financial contagion due to interbank linkages and study its implications.

The article find robust evidence that higher interbank exposure to the failed bank generates large deposit withdrawals. The article find that the probability of facing large deposit withdrawals increases by 34 percentage points if a bank has a high level of exposure. Moreover, we find that the impact of exposure on deposit withdrawals is greater for higher levels of exposure, thus suggesting a nonlinear effect of bank exposure on deposit withdrawals. The article then explore the further implications from interbank contagion. The article first explore whether stronger bank fundamentals play a role in reducing the magnitude of contagion. Specifically, we find that the impact of exposure on deposit withdrawals is higher if:

* banks have a lower level of capital,

* banks are smaller in size, and

* banks are classified as weak by the regulator.

These results suggest that weaker fundamentals of the banking system amplify the magnitude of interbank contagion. This suggests that contagion is stronger when the ...