Credit Contagion Channels: Market Microstructure Evidence from Lehman Brothers’ Bankruptcy

Abstract

Immediately after Lehman Brothers’ bankruptcy, many firms disclosed their financial exposure (or lack thereof) to Lehman. This offers a clean setting to test two credit contagion channels through which a financial firm's bankruptcy can affect other firms—“counterparty risk” and “information transmission” channels. Using market microstructure variables to measure the various dimensions of contagion effects, we provide robust evidence supporting the significance of counterparty risk. Firms with exposure to Lehman suffered more severe negative effects—wider bid‐ask spread, higher price impact, greater information asymmetry, and greater selling pressure—than unexposed firms. We find mixed evidence regarding the information transmission hypothesis.

Bank capital, interbank contagion, and bailout policy

“…4 Given the complexity of interbank linkages, counterparty risk is even more worrisome for financial institutions. In the spirit of our model, whether other banks will fail in the wake of the 4 Empirically the counterparty contagion hypothesis is supported by Hertzel et al (2008), Jorion and Zhang (2009), Brunnermeier (2009), Chakrabarty and Zhang (2012, and Iyer and Peydro (2011), among others. As Helwege (2009) points out, government bailout is necessary if counterparty contagion is a major contagion channel for financial firms.…”

Financial Firm Bankruptcy and Contagion

“…Our paper is closely related to Jorion and Zhang (2009) (2011)). Information contagion from financial firm failures is examined by Aharony and Swary (1983), Fenn and Cole (1994), Fields, Ross, Ghosh, and Johnson (1994), Fields, Klein, and Myskowski (1998), Jorion and Zhang (2012 and Chakrabarty and Zhang (2012). However, few of these authors consider counterparty risk and most examine a small sample of distressed financial firms.…”

“…Other related papers include Ivashina and Scharfstein (2010), who examine linkages between banks and their borrowers, and Furfine (2003), who uses data on interbank fund flows to simulate the impact of various failure scenarios. In addition, several studies of counterparty contagion in the wake of the financial crisis are based on a single large bankruptcy, such as that of Lehman (Aragon and Strahan (2012), Chakrabarty and Zhang (2012), Fernando, May and Megginson (2012), and Jorion and Zhang (2012)) or a large bank in India (Iyer and Peydró (2011)). …”

“…Thus, their results may understate the extent of contagion arising from financial firms in financial crises. Studies that examine Lehman's collapse and firms with which it had direct business ties find a significant negative impact (Ivashina and Scharfstein (2010), Aragon andStrahan (2012), Fernando, May andMegginson (2012), Jorion and Zhang (2012), and Chakrabarty and Zhang (2012)). Using data from the subprime crisis, Arora, Gandhi and Longstaff (2012) examine counterparty risk in CDS contracts while Iyer and Peydró (2011) provide evidence of counterparty contagion from a large bank failure in India.…”

“…However, most existing studies on information contagion fail to control for counterparty effects. Exceptions are Jorion and Zhang (2012) and Chakrabarty and Zhang (2012) The relationship between size and information is not clear: While large firms' failures may impact all firms with related assets, simply because failures of large firms induce more reporting, small firm bankruptcies may be more relevant for other small firms in the same geographic locale because they have similar investments and funding sources.…”