Authors: Falko Fecht (Frankfurt School), Co-Pierre Georg (Deutsche Bundesbank and University of Cape Town) and Melissa Schultheis (Deutsche Bundesbank and Goethe University Frankfurt)
Title: Forward Contagion
Abstract: Do banks that are hit by a shock to their funding liquidity propagate this shock to other banks via the interbank market? If so, this would create the potential for forward contagion from a lender to a borrower bank which should be even stronger if there is a strong lending relationship between lender and borrower. Forward contagion is different from the standard contagion process that works from borrowers to lenders, e.g. if a borrower defaults on its obligation to the lender. The project is based on interbank lending and tender auction data as well as detailed bank characteristics from 2006 to 2007, i.e. the period when the global financial crisis caused substantial stress in euro area interbank markets. We use liquidity provition via variable rate tender auction of the ECB to construct liqudity shocks of banks and we use them to estimate the effect on interbank lending behaviour.
We find a significant increase in loan spreads, using loan level data, if the lending bank is hit by a negative liquidity shock. Furthermore this result can be approved on lender and on borrower level using different samples. In addition it seems as if lender with a negative liquidity shock try to compensate the shock via borrowing on the interbank market by paying higher interest rates.