A study of contagion in global and local banking industries

This thesis investigates contagion risk for the global and local banking environment using three different distance to risk measures (distance to default - DD, distance to capital – DC and distance to inefficiency- DI). In order to achieve this goal, the research has been divided into three parts (each will have its own chapter) to study the contagion effect in the global and local market. In the first part (chapter 4), the thesis investigates the contagion effect among the top 20 countries of the world. The sample consists of 91 banks from 20 countries across the globe including all G8 and BRICS countries. A list of all these countries and their corresponding banks is included later. The sample also includes all the GSIB (Global systematically important banks) banks excluding Group BPCE of France (given that Group BPCE originated in year 2009 by merging Caisse nationale des caisses d'épargne and Banque fédérale des banques populaires). In the second part (chapter 5), the thesis examines the local contagion by studying the spill over among top 15 US states. The sample consist of four of the largest banks from each of the sample 15 US state. A list of these banks is attached in the sample description. In chapter 6, the thesis performs a spill over analysis using DD, DI and DC. In order to do so, the thesis has measured the systemic risk using distance to default, distance to inefficiency and distance to capital, which are introduced by the option pricing theory (Merton, 1976). These distance to risk methods are defined as the theoretical difference between the entity’s current and breakeven risk position (Distance to default is the difference between the current and default position; Distance to inefficiency is the difference between the current and inefficient position and distance to capital is the difference between the current and default capital threshold position). Any position lower then this distance to risk measures is considered undesirable for the entity. The study has calculated 2606 daily observations for each of the different distance to risk measures for each bank in the sample for approximately 10 financial years from 2006 to 2015. Then the thesis compute the probability of experiencing extreme shocks in these distance measures of contagion risk using extreme value threshold. This research categorizes these extreme shocks into sub groups for the first two parts and keep the extreme shock unchanged for the last part and examine the contagion risk ascending from the movement of these extreme systemic shocks all through the US and global baking environment using multinomial logistic regression model (MLM). Finally, in chapter 7, the thesis discussed a possible risk management framework based on findings of the previous chapters. It has taken all the banks and divided them into 4 tiers based on their spill over impact. The study suggests that any bank in the 1st tier of the short term or long-term contagion capacity table should be referred to a high degree of regulatory control to enforce not only better capital governance or liquidity requirement but to also enforce overall financial governance as they have a huge impact on the other financial institutions. For the banks in the second and third tier, the authority may adopt a more gradually enforceable governance control in lieu with the current practice and the last tier can do their business in the current regulation, as they pose no real threat to the other peers. At the end, the study also suggests a new generic risk management framework for financial institutions