Contagion effects resulting from bankruptcy announcements have long been the focus of empirical analyses. The majority of the literature has examined bankruptcy of non-financial firms. In the banking industry, however, failure of a firm is different than for non-banks. Specifically, unlike any other industry, a failing bank can not be closed until regulators evaluate the situation for its impact on the safety and soundness of the financial system, arrange a purchaser of the bank’s assets and liabilities (or another liquidation method), and declare the bank closed. Additionally, before 1997 and the enactment of the Reigle-Neal Interstate Banking and Branching Efficiency Act, banks were not completely free to expand outside their local area. While many banks and their home states had regional reciprocity laws (banks could expand across state lines with neighboring states), complete nationwide expansion was virtually nonexistent. Thus, unlike failures in non-banking industries, a bank failure is more likely to have a direct impact on the performance of rival banks in the failing bank’s local area.
In an attempt to clarify the nature of bank failure related contagion on U.S. banks, Aharony and Swary (1996) examine information-based elements of bank failures using large bank failures occurring in the southwest U.S. in the 1980s. They find that the closer the rival bank is to the failing bank the stronger the contagion effect; the larger the rival bank the stronger the contagion effect; and the higher the rival banks’ leverage the more negative the impact. They conclude that regional bank failures should send a “red flag” to regulators indicating additional banks in the region may be problematic.
Akhigbe and Madura (2001) further address the cross-sectional variation of contagion effects as well as the risk shifts that are associated with announced bank failures. Their findings suggest that contagion effects are stronger when the failing bank is a multibank holding company, is large, or is publicly held. They further suggest that contagion is heightened when the surviving rival bank is relatively small and when its capital levels are relatively low. They also find that the contagion effect decreases after the passage of the Financial Institutions Reform Recovery and Enforcement Act (FIRREA) of 1989.
In assessing the effects of closure policies on surviving banks, Davies and McManus (1991) conclude that increasing closure levels may have unintended consequences. Depending on the bank, increases in closure levels by regulators may increase or decrease asset risk for otherwise healthy banks. Similarly, increasing closure levels can potentially increase or decrease the level of leverage desired by managers and/or owners. Garcia (1995) examines the FDIC Improvement Act (FDICIA) and its mandatory closure rule. He shows how the mood of regulators can change dramatically through time. While forbearance was encouraged after the Competitive Equality Banking Act (CEBA) of 1987, it was explicitly discouraged after the passage of FDICIA. Although the Prompt Corrective Action (PCA) clause of FDICIA did mandate closure of certain distressed institutions, regulators were not completely stripped of their ability to impose sanctions at their discretion. Thus, the strength of the signal that regulators send by closing a bank varies depending on the regulatory environment.
Existing research finds that bank failures result in industry-wide shocks in the short run. However, no study has cross-sectionally examined the long-term implications of bank failures on rival banks. While a short run analysis of bank failures allows for the evaluation of investor’s expectations of future performance changes for rival banks around a bank failure, long-term analysis of rival banks allows for the evaluation of actual changes in performance around a bank failure. As regulators set policy regarding the evaluation of a bank failure for its impact on the safety and soundness of the financial system, actual changes in the long-term operating performance of surviving banks around a bank failure rather than expectations of future performance changes by investors are most relevant.
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