Bad News Bankers: Underwriter Reputation and Contagion in Pre-1914 Sovereign Debt Markets

Abstract

This paper uses new bond-level data on sovereign borrowing and defaults during 1869-1914 to quantify a channel of contagion via banks' reputation for monitoring borrowers. Concerns over reputation incentivized Britain's merchant banks (who underwrote sovereign bonds) to monitor and exert influence over sovereigns. Default signaled to investors that a bank was less willing or able to write and support quality issues, indicating that its other bonds may underperform in the future. Consistent with reputation-based contagion, I find that comovement between defaulting and non-defaulting bonds is six times larger when the bonds share an underwriter. To isolate the causal effect of a shared underwriter, I exploit within-country variation in bonds' underwriters. Testing predictions from a dynamic game where underwriters build a reputation for monitoring, I find further evidence supporting reputation as the mechanism -- as opposed to alternative explanations such as wealth effects. These findings highlight that the reputation of intermediaries that monitor and intervene in crises can be a powerful source of contagion unrelated to a borrower's fundamentals.

Keywords: contagion, sovereign default, financial intermediaries, reputation, pre-1914, international financial markets

JEL Classification: F34, F42, G14, G15, G24, N20