Reputational Contagion and Optimal Regulatory Forbearance

34 Pages Posted: 25 May 2010

See all articles by Lucy White

Lucy White

Centre for Economic Policy Research (CEPR); Boston University - Department of Finance & Economics

Alan D. Morrison

University of Oxford - Said Business School; University of Oxford - Merton College

Multiple version iconThere are 2 versions of this paper

Date Written: May 10, 2010

Abstract

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.

Keywords: Contagion, Reputation, Bank Regulation

JEL Classification: G21, G28

Suggested Citation

White, Lucy and Morrison, Alan, Reputational Contagion and Optimal Regulatory Forbearance (May 10, 2010). ECB Working Paper No. 1196, Available at SSRN: https://ssrn.com/abstract=1603860 or http://dx.doi.org/10.2139/ssrn.1603860

Lucy White

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Boston University - Department of Finance & Economics ( email )

595 Commonwealth Avenue
Boston, MA 02215
United States

Alan Morrison (Contact Author)

University of Oxford - Said Business School ( email )

Department of Finance
Park End Street
Oxford OX1 1HP
United Kingdom
+44 18 6527 6343 (Phone)
+44 18 6527 6310 (Fax)

University of Oxford - Merton College

Merton Street
Oxford OX1 4JD
United Kingdom
+44 18 6527 6343 (Phone)

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