Pocket Banks and Out-of-Pocket Losses: Links between Corruption and Contagion

The author describes a model with a corrupt banking system, in which bankers knowingly lend at market interest rates to back projects riskier than the market rate indicates. Faced with early withdrawals, bankers turn to an interbank market, which may be available in an unfettered way, available but subject to screening, or unavailable. The presence of corruption increases the probability of contagious bank failure significantly. This fact holds in a perfect information environment, as well as in some environments with imperfect information. The model suggests that financial stability can be imperilled by corrupt lending.