Bad or good neighbours: a spatial financial contagion study

Abstract

PurposeThe purpose of this paper is to study the evolution of financial contagion between Eurozone banks, observing the credit default swaps (CDSs) market during the period 2009–2017.Design/methodology/approachThe authors use a dynamic spatial Durbin model that enables to explore the direct and indirect effects over the short and long run and the transmission channels of the contagion.FindingsThe results show how contagion emerges through physical and financial market links between banks. This finding implies that a bank can fail because people expect other related financial institutions to fail as well (self-fulfilling crisis). The study provides statistically significant evidence of the presence of credit risk spillovers in CDS markets. The findings show that equity market dynamics of “neighbouring” banks are important factors in risk transmission.Originality/valueThe research provides a new contribution to the analysis of EZ banking risk contagion, studying CDS spread determinants both under a temporal and spatial dimension. Considering the cross-dependence of credit spreads, the study allowed to verify the non-linearity between the probability of default of a debtor and the observed credit spreads (credit spread puzzle). The authors provide information on the transmission mechanism of contagion and, on the effects among the largest banks. In fact, through the study of short- and long-term impacts, direct and indirect, the paper classify banks of systemic importance according to their effect on the financial system.