Information Contagion and Systemic Risk

12 June 2017
Publication Type: Working Paper
JEL Code: D11, D8, D81, G01, G21

We examine the effect of ex-post information contagion on the ex-ante optimal portfolio choices of banks and the welfare losses due to joint default. Because of counterparty risk and common exposures, bad news about one bank reveals valuable information about another bank, thereby triggering information contagion. Systemic risk is defined as the ex-ante probability of joint bank default ex post. We find that information contagion increases systemic risk when banks are subject to common exposures since portfolio adjustments are small. In contrast, when banks are subject to counterparty risk, information contagion induces a large shift toward more prudential portfolios and therefore reduces systemic risk.

Working paper 686
1 June 2017