Contagion through common borrowers

Sonny Biswas, Fabiana Gómez*

*Corresponding author for this work

Research output: Contribution to journalArticle (Academic Journal)

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Abstract

We propose a model in which banks are exposed to the risk of contagion through their portfolio of loans. We show that a solvency problem in one bank can be transmitted to another if they lend to the same borrower. The novelty is that the channel for the transmission involves banks’ monitoring incentives. The intensity with which all banks monitor a common borrower is reduced when one of the banks suffers a solvency shock. The reduced effort intensity affects the borrower's probability of success and creates a contagion (endogenous correlation) from the balance-sheet of the affected bank to the balance-sheet of the other banks lending to the same borrower. Banks hit by a solvency shock have lower incentives to monitor borrowers because less is left after paying depositors. Banks not hit by a solvency shock face borrowers’ risks entirely on their own, which increases the expected cost of lending. As a consequence, they respond by reducing the monitoring intensity for the common borrower. Bank equity can mitigate the risk of contagion.

Original languageEnglish
Pages (from-to)125-132
Number of pages8
JournalJournal of Financial Stability
Volume39
Early online date3 Nov 2018
DOIs
Publication statusPublished - 1 Dec 2018

Structured keywords

  • AF Banking

Keywords

  • Financial contagion
  • Monitoring incentives
  • Syndicated loans
  • Systemic risk

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