Do bank scandals create winners or breed distrust?

Trouble at one bank usually sends deposits to its neighbours, but it can drain the whole neighbourhood during a crisis

Featured faculty: Bella Kang Ya
Written by Joanne Madrid

Bank failures are surprisingly not that rare. Forbes recently reported that, on average, around 22 US commercial banks have failed annually since 2000. Most of them are small banks, including six so far this year. Banking rests on a simple bargain. Depositors trust banks to keep their money safe, and banks use that money to fund their lending. Devastating news, whether about a disappointing earnings report, bad investments, asset losses, or a nudge from regulators, could break that trust.

Once it breaks, depositors no longer feel secure and move their money out of the troubled bank, but where would they go? Bella Kang Ya, Assistant Professor in the School of Accountancy at the Chinese University of Hong Kong (CUHK) Business School, finds the choice depends on whether people see the scale of the problem.

“Healthy banks come out ahead by gaining deposit inflows and effectively absorbing market share from the troubled bank,” says Professor Kang. “However, during economic instability or a financial crisis, even healthier local banks also see customers withdrawing their money, and this can trigger a worsening spiral for all banks.”

Depositors normally view misconduct as specific to the troubled bank and move their savings to safer banks. But when they see news of multiple banks struggling and major economic indicators falling, all banks are perceived as risky as a broader panic sets in.

Follow the money

In collaboration with Lin Yupeng of the National University of Singapore and Qiu Yang of Zhejiang University, Professor Kang’s study, A tale of two market disciplines: How does bank financial misconduct affect peer banks in the local deposit market, examines the Consolidated Reports of Condition and Income of all US commercial banks from 2007 to 2021.

The team identifies 3,727 misconduct cases committed by 2,858 banks in which regulators forced banks to correct previously reported figures, peaking in 2007–2008 and rising again in 2020.

They then track the interest rates individual banks offered on large deposits above US$250,000. Deposits beyond this amount are most likely to run, since they are not fully insured by the government, and normally belong to financially sophisticated entities and institutional investors.

Banks caught in misconduct quickly lost deposits and offered higher interest rates to attract depositors. However, the nearby rival banks attracted more customers, even after offering lower interest rates on large deposits, around 25 per cent less. In the following year, deposits at these rival local banks grew faster than at other branches located far from the troubled bank.

A clear pattern appears. If a bank has to offer much higher interest rates than other banks just to attract depositors, it typically means people are withdrawing their deposits. On the other hand, if a bank can offer lower rates and still attract many new depositors, it means more money is flowing in.

The researchers call this “reallocation effect,” and it serves as market discipline. As Professor Kang puts it, “the offending bank struggles to get funding, must pay more interest to depositors, and may lose market share in the long run. This penalty ultimately benefits its competitors.”

How depositors spot better banks

There is direct evidence of large depositors doing their homework. After examining company filings on the online database of the US securities regulator, Professor Kang finds that areas with increased searches about the troubled bank saw deposits move the most.

These deposits moved to rival banks with stronger capital and healthier balance sheets, and they were especially active in areas with higher levels of education and financial literacy, as those who can read a financial statement act first.

“The offending bank struggles to get funding, must pay more interest to depositors, and may lose market share in the long run. This penalty ultimately benefits its competitors.”

Professor Bella Kang Ya

“Financially sophisticated depositors are more responsive and drive stronger reallocation effects, since they have the incentive and capacity to monitor bank health,” she adds.

Financially savvy depositors also know how to tell a bookkeeping error from a serious financial problem. When a bank reported committing misconduct but is otherwise financially strong, depositors are less inclined to withdraw their funds.

When discipline turns into panic

The team rerun the same analysis for 2007 and 2008, when the financial crisis struck, and the story changes. Instead of moving next door, most banks in affected areas lost deposits and had to pay about 8.7 per cent more than the usual interest rates to attract depositors. The researchers call this “contagion effect,” and the danger is that it feeds on itself.

“During a crisis, banks face deposit outflows and rising deposit spreads simultaneously, meaning they must pay more for a shrinking customer base, precisely when liquidity is most valuable,” says Professor Kang. “If sustained, this issue can impair lending capacity, default risk, and, in severe cases, contribute to systemic bank runs.”

As financial technology advances, both local and contagion effects are now amplified. The 2023 US banking crisis, where depositors pulled US$42 billion out of Silicon Valley Bank within hours, is a clear example. In the previous 2008 crisis, bank runs took several days or weeks.

“Depositors now can reallocate funds in minutes, while social media and financial news accelerate the spread of negative sentiment, shortening the window for banks and regulators to take action,” she adds. “Digital banking also helps contagion effects expand beyond the district where the troubled bank operates to any bank that shares similar risks.”

The last banking crisis not only collapsed three major US banks but also affected more than 20 other banks due to severe deposit runs. Depositors flocked to bigger national banks, like JPMorgan Chase and Bank of America, as well as government-backed funds, where they felt more secure.

How to control the contagion

To mitigate local and contagion effects that could spiral into more devastating outcomes, Professor Kang notes a state-contingent disclosure and intervention framework could work. This framework consolidates information on what a bank must publicly disclose and when the regulator steps in.

During a crisis, bank disclosure that enhances transparency can trigger contagion effects that harm other healthier banks. Therefore, regulators should at once provide financial support, clearly explain that the problem is isolated, and closely watch banks with similar risks.

“Banks should monitor the regulatory and financial health of local peer banks, given that early awareness of distress allows preemptive liquidity planning,” she adds. “Visibly strong capital ratios, asset quality, and diversified funding are a must since contagion is likely attenuated for those with strong balance sheets.”

Banks should also diversify their depositor base to reduce vulnerability to a homogeneous and easily spooked pool of depositors. Maintaining robust contingency funding plans and pre-arranged access to liquidity facilities provides a credible backstop that banks can communicate to depositors.

Finally, banks should track early warning indicators such as rising deposit spreads relative to other local peers, unusual spikes of withdrawals from large depositors, negative sentiment in local media and social media, and stock price movements among similarly structured local banks, all of which can signal impending contagion risk before it turns into a full bank run.