Financial Firm Bankruptcy and Contagion

Abstract

The Lehman bankruptcy highlights the potential for interconnectedness among financial firms to cause a financial crisis. Previous research shows that Chapter 11 filings cause significant negative externalities, consistent with a strong role for counterparty contagion. However, the effects may also arise from information contagion, where one firm’s default or news of distress leads investors to update their valuations of related securities. We examine bankrupt and distressed financial firms to evaluate the roles of counterparty contagion and information contagion and find that both forms have significant effects on other firms’ stock returns. While significant, both information contagion and counterparty contagion effects are modest for most financial firm bankruptcies. Low counterparty risk likely reflects the fact that many financial firms are required by regulators to hold diversified portfolios.

Keywords: Banks, counterparty contagion, information contagion, bankruptcy

JEL Classification: G21, G24, G28, G32, G33, E44, E58, E61