Zhen Zhou (Tsinghua University) - The Consequences of a Small Bank Collapse: Evidence from China

Co-authors: Liyuan Liu (PBC School of Finance, Tsinghua University) and Xianshuang Wang (PBC School of Finance, Tsinghua University)

Upon assuming control of Baoshang Bank, Chinese bank regulators announced that they would eschew bailing out large creditors of this city-level distressed bank in full. This paper investigates the consequences of this unexpected deviation from the long-standing full bailout policy. Employing a difference-in-difference methodology, we find that this event significantly increased credit spreads and decreased the funding ratio of negotiable certificates of deposit (NCD) issued by systemically unimportant (SU) banks relative to those issued by systemically important (SI) banks. The deterioration of funding conditions for SU banks is economically significant and persistent, resulting in the distress of more SU banks. This finding demonstrates that deviating from a widely anticipated bailout, even for a small bank, can jeopardize expost financial stability due to a decline in market confidence regarding future bailouts. Ex-ante, however, it is found that the induced implicit non-guarantee improves price efficiency and credit allocation, strengthens creditors’ monitoring, and reduces the risk-taking of SU banks.

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