Contagion via Financial Intermediaries in Pre-1914 Sovereign Debt Markets

This paper uses new data on the timing of sovereign defaults during 1869-1914 to quantify an informational channel of contagion via shared financial intermediaries. Concerns over reputation incentivized Britain’s merchant banks to monitor, advise, and occasionally bail out sovereigns. Default signaled to investors that a merchant bank was not as willing or able to write and support quality issues, suggesting that its other bonds may underperform in the future. In support of this channel, I find that during a debt crisis, a 5% fall in the defaulting bond’s price leads to a 2.19% fall in prices of bonds sharing the defaulter’s bank. This is substantial compared to the 0.24% price drop among bonds with different banks. Information revelation about financial intermediaries can be a powerful source of contagion unrelated to a borrower’s fundamentals. In modern financial markets, third parties such as credit rating agencies, the IMF, or the ECB could similarly spread contagion if news about their actions reveals information about their willingness to monitor risky borrowers or intervene in crises.