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Information Contagion and Inter-Bank Correlation in a Theory of Systemic Risk

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  • Acharya, Viral V
  • Yorulmazer, Tanju

Abstract

Two aspects of systemic risk, the risk that banks fail together, are modeled and their interaction examined. First, the ex-post aspect, in which the failure of a bank brings down a surviving bank as well, and second, the ex-ante aspect, in which banks endogenously hold correlated portfolios increasing the likelihood of joint failure. When bank loan returns have a systematic factor, the failure of one bank conveys adverse information about this systematic factor and increases the cost of borrowing for the surviving banks. Such information contagion is thus costly to bank owners. Given their limited liability, banks herd ex-ante and undertake correlated investments to increase the likelihood of joint survival. If the depositors of a failed bank can migrate to the surviving bank, then herding incentives are partially mitigated and this gives rise to a pro-cyclical pattern in the correlation of bank loan returns. The direction of information contagion, the localized nature of contagion and herding, and the welfare properties, are also characterized.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 3743.

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Date of creation: Feb 2003
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Handle: RePEc:cpr:ceprdp:3743

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Keywords: contagion; herding; information spillover; interbank correlation; procyclicality; systemic risk;

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Cited by:
  1. Allen N. Berger & Gregory F. Udell, 2003. "The institutional memory hypothesis and the procyclicality of bank lending behaviour," BIS Working Papers 125, Bank for International Settlements.
  2. Oliver Arentz & Johann Eekhoff & Christine Arentz, 2010. "Zur Finanzmarktkrise: Die Rolle der Immobilienbewertung," IWP Discussion Paper Series 01/2010, Institute for Economic Policy, Cologne, Germany.
  3. de Vries, Casper G & Hartmann, Philipp & Straetmans, Stefan, 2004. "Fundamentals and Joint Currency Crises," CEPR Discussion Papers 4338, C.E.P.R. Discussion Papers.
  4. Moheeput, Ashwin, 2008. "Financial Fragility, Systemic Risks and Informational Spillovers : Modelling Banking Contagion as State-Contingent Change in Cross-Bank Correlation," The Warwick Economics Research Paper Series (TWERPS) 853, University of Warwick, Department of Economics.
  5. Moheeput, Ashwin, 2008. "Financial Systems, Micro-Systemic Risks and Central Bank Policy : An Analytical Taxonomy of the Literature," The Warwick Economics Research Paper Series (TWERPS) 856, University of Warwick, Department of Economics.

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