Bank defaults and spillover effects in US local banking markets

I examine the spillover effect of a bank default on its neighboring banks over the 2007Q1-2015Q4 period propagating through the disrupted local economic activity in areas the failed institution was operating in through its branches. The results show that the affected neighboring banks’ insolvency risk increases considerably one year after the shock, especially during the crisis. This effect is driven by capital deterioration, increase in non-performing loans and a surge in the volatility of profits. Moreover, this spillover effect is asymmetrically distributed, impinging more neighboring banks that bear higher risk whereas better capitalized ones are not better shielded. Policy implications of these findings are discussed.