Information effects of First Republic Bank's failure

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Abstract
An overriding concern in the US financial system is an event or rumour that reduces public confidence in banks. The existence of regulatory agencies in the banking system is largely motivated by this concern (see Aharony and Swary (1983)). Regulatory decisions on deposit rate ceilings, interstate branching, non-bank services, minimum capital ratios, and even the tax writeoffs on bad debt are driven by the desire to restore customer and investor confidence. Whereas some bad news is bank-specific, other news about a particular bank can signal severe ramifications for the banking industry as a whole. Two conditions are typically necessary for unanticipated news of a single bank's financial distress to have an information effect: (1) the bank must be well-known across the nation or have substantial significant business relationships with many other banks, and (2) the underlying factors that led to the financial distress could also cause other banks to experience similar problems. One of the more extreme conditions that could have an information effect is an anticipated or actual bank failure. Aharony and Swary (1983) suggest that a single bank's failure could potentially reduce the public's confidence in the banking system. While hundreds of bank failures have gone unnoticed by the public in recent years, most of these banks lack size, notoriety, or significant relationships with many other banks. Yet, the financial distress of First Republic Bank (FRB) in 1987 is arguably the most likely event to have an information effect throughout the banking industry in recent years. Our objective is to assess the market reaction of other bank's stock prices to news about FRB's financial distress. Results of the analysis used to achieve this objective offer implications regarding the likelihood of spillover effects across banks. The implications are significant not only to banks susceptible to a contagion effect but to regulators as well.