Spillovers and Long Run Difussion of Non-Performing Loans Risk

This paper analyzes the diffusion and spillover effects of credit risk among banks within a banking system, using the Mexican financial system as a case study. Credit risk is measured by the non-performing loans ratio (NPL). Our method builds on work by Diebold and Yilmaz (2009) to decompose spillovers observed among banks' portfolio risk. The method allows us to measure the long-run contributions of each bank's risk on the rest of the banking system through the diffusion of risk among intermediaries. Moreover, we are able to gauge the relative importance of spillover by increasing the length of prediction periods for each bank's NPL. Our estimations for the Mexican banking system between 2000 and 2010 suggest that the overall spillover effect index accounts for 60 to 75 percent of the observed variation and that the longer the time period we consider, the stronger this spillover effect is. Moreover, contrary to the common view, the spillover effect realized through the diffusion of risk is bidirectional between small and large banks, rather than only one type affecting the other