A Nonparametric Test for Financial Contagion with Application to the Canadian Banking System

This paper proposes a new test of financial contagion based on a nonparametric measure of the cross-market correlation. The test does not depend on the assumption that the data are drawn from a given probability distribution, therefore it allows for maximal flexibility in fitting into the data. Simulation studies show that our test has reasonable size and good power to detect financial contagion, and that the Forbes and Rigobon’ test (2002) is conservative, suggesting that Forbes and Rigobon’ test will tend not to find evidence of contagion when it does exist. The test is applied to investigate financial contagion of a variety of recent financial crises to the Canadian banking system. The empirical results reveal that: (i) compared to recent financial crises including the 1987 US stock market crash, 1994 Mexican Peso crisis, and 1997 East Asian Crisis, the ongoing 2007 subprime crisis has been having more persistent and stronger contagion impacts on the Canadian banking system; (ii) the October 1997 East Asian crisis induced contagion to Asian countries, and it quickly spread across Asian and to Latin America, and G7 countries. The contagious persistency of this crisis to the Canadian banking system was not as strong as the ongoing subprime crisis. However, it had a stronger impact on emerging markets; (iii) there was no evidence of contagion from the 1994 Mexican peso crisis to the Canadian banking system. Contagion occurred to Argentina, Brazil, and Chile, but it was only constrained in the region of Latin America. ∗The author is grateful to Jason Allen, Allan Crawford, Toni Gravelle, Pierre St-Amant, and Greg Tkacz for helpful comments and suggestions. The author would also like to thank seminar participants at the Bank of Canada. Address correspondence to: Fuchun Li, Financial Stability Department, Bank of Canada, Ottawa, ON, K1A 0G9, Canada; e-mail: [email protected]