From collapse to contagion: How bank failures influence stock markets

This paper investigates the effects of bank failures on abnormal stock returns and volatility spillovers within the U.S. banking sector between 2001 and 2024. Building on the systemic risk framework proposed by Diebold and Yilmaz (2012), we expand the existing literature by analyzing how perception-driven market responses amplify contagion risks beyond direct financial linkages between banks. Our findings reveal that bank failures have both statistically and economically significant negative impacts on bank stock market returns, with evidence of anticipatory and lagged effects associated with these events. In terms of systemic risk and contagion potential, the impact of bank failures appears to be limited. However, our results suggest that bank failures could have a more pronounced negative impact in the future under conditions such as low bank profitability, poor cost efficiency, increasing portfolio risks, and deteriorating macroeconomic conditions. Additionally, our findings provide new evidence on the role of irrational contagion, demonstrating that market participants respond also to perceived weaknesses. These insights offer valuable information for investors, bank shareholders, regulators, policymakers, and financial institutions.