VoxEU: Determinants of banking system fragility - A regional perspective

21 March 2012

This column looks at the effect of bank fragility and failure on other nearby countries, and outlines what can be done to mitigate the cross-border contagion.

It is well known that banks face shocks both on their asset and liability side. A shock that initially affects one institution can become systemic and infect the larger local economy. The globalisation of banking implies further that shocks affecting a particular bank or country can now affect not only the local real economy but also the financial system and real economy in other countries.

The current academic literature on financial fragility, however, has mainly focused on stability of individual banks or stability of individual countries’ banking systems, but has disregarded regional banking system fragility. This column describes the findings of a recent empirical study of the determinants of regional banking system fragility and considers liquidity, capitalisation, competition, diversification and presence of foreign banks in a region. These are motivated as follows:

• The liquidity on a bank’s balance sheet serves as a first line of defence against liquidity shocks.
• A higher capital base provides a cushion against insolvency.
• The relationship between competition and financial stability is complex.
• Diversification of bank activities may improve or deteriorate banking stability.
• The presence of foreign banks in a region may impact the fragility of the regional banking system in different ways. On the one hand, a greater foreign bank presence may lead to greater banking efficiency and competition in the domestic financial system. On the other hand, foreign banks may provide a channel for cross-border contagion when they transmit shocks from one region to another.

Main findings:

• A region’s banking system characteristics play a significant role in explaining regional banking system fragility:
  • Higher liquidity reduces regional banking system fragility in all regions.
  • Higher capitalisation reduces regional banking system fragility in all regions with the exception of Asia and Europe, where it has no effect.
  • These findings are supportive of the competition-stability view in most regions as an increase in competition in the banking industry significantly reduces coexceedances.
  • A focus on traditional loan-making activities increases the likelihood of a single country in the bottom tail, but there is no significant impact on joint occurrences of extreme negative returns in the region.
  • A greater presence of foreign banks reduces regional banking fragility in Asia and Latin America.
• Within-region contagion is higher in emerging market regions compared to developed regions, and is stronger in Latin America than in Asia.
• For cross-regional contagion, the column finds that the contagion effects of Europe and the US on Asia and Latin America are significantly higher compared to the effect of Asia and Latin America among themselves.
• A higher level of liquidity and capital in the host region attenuate significantly the contagion effects from other regions.

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