Financial Firm Bankruptcy and Contagion

The Lehman bankruptcy highlights the potential for interconnectedness to cause negative externalities through counterparty contagion, but the externalities may also arise from information contagion. We examine troubled financial firms and find that both channels are significant factors in creating spillover effects. Counterparty contagion is greater in cases of riskier firms and larger and more complex exposures. However, the counterparty exposures are small, especially among banks that face diversification regulations, and do not typically cause a cascade of failures. Information contagion is stronger for rivals in the same markets and has a larger impact in cases of distress than in bankruptcies.