Mandatory Disclosure and Financial Contagion

The paper analyzes the welfare implications of mandatory disclosure of losses at financial institutions when it is common knowledge that some banks have incurred losses but not which ones. We develop a model that features "contagion," meaning that banks not hit by shocks may still suffer losses because of their exposure to banks that are. In addition, banks in our model have protable investment projects that require outside funding, but which banks will only undertake if they have enough equity. Investors thus value information about which banks were hit by shocks. We find that when the extent of contagion is large, it is possible for no information to be disclosed in equilibrium but for mandatory disclosure to increase welfare by allowing investment that would not have occurred otherwise. Absent contagion, however, mandatory disclosure will not raise welfare, even if markets are otherwise frozen. Our findings provide insight on when contagion is likely to be a concern, e.g. when banks are highly leveraged against other banks, and thus on when mandatory disclosure is likely to be desirable.