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

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.