Financial Firm Bankruptcy and Contagion

The Lehman bankruptcy highlights the potential for interconnectedness to cause negative externalities through counterparty contagion, but the externalities may also arise from information contagion. We examine contagion from troubled financial firms and find that counterparty contagion is greater during recessions and in cases of riskier firms and larger and more complex exposures. However, the counterparty exposures are small, especially among banks that face diversification regulations, and do not typically cause a cascade of failures. Information contagion is stronger for rivals in the same locale or the same line of business and is stronger in cases of distress than in bankruptcies. 1When companies file for bankruptcy other firms in the same industry often suffer as a result. Lang and Stulz (1992) conclude that rivals ’ stocks drop in response to the news because investors learn about future industry cash flows from the filing. Consistent with their work, Jorion and Zhang (2007) report that credit default swap (CDS) premiums typically rise for firms in the same industry after a default. Theocharides (2008) and Hertzel and Officer (2012) sho