DP9508 Reputational Contagion and Optimal Regulatory Forbearance

Author(s): Alan Morrison, Lucy White
Publication Date: June 2013
Keyword(s): bank regulation, contagion, reputation
JEL(s): G21, G28
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=9508

Existing studies suggest that systemic crises may arise because banks either hold correlated assets, or are connected by interbank lending. This paper shows that common regulation is also a conduit for interbank contagion. One bank?s failure may undermine confidence in the banking regulator?s competence, and, hence, in other banks chartered by the same regulator. As a result, depositors withdraw funds from otherwise unconnected banks. The optimal regulatory response to this behaviour can be privately to exhibit forbearance to a failing bank. We show that regulatory transparency improves confidence ex ante but impedes regulators? ability to stem panics ex post.