Contagion (Finance)

News of a bankruptcy could affect the trading positions and equity values of other companies in the same industry simply because a lack of information encourages the presumption that the circumstances of the bankrupt firm apply more generally. This phenomenon is referred to as contagion. Other examples of initializing news events and possible contagious consequences include the impact of the closure of an insolvent bank on the operations and market value of other banks and the effect that the debt-servicing difficulties of a sovereign borrower might have on (1) banks with loan exposures to similar countries and (2) lender perceptions of the creditworthiness of similar countries and therefore the spreads and/or ceilings on loans that they are prepared to offer .

Although contagion is often implicitly linked to irrationality it may turn out to be beneficially rational, for example where news of a bankruptcy provides an early warning of problems that are common to an industry as a whole. The alternative situation is sometimes referred to as “pure” contagion, the wider consequences of which might include the instabilities of inefficient markets, including perhaps crisis proportion failures of confidence, and lost opportunities for portfolio diversifications because of increasing event dependence, i.e. systematicity.

As may be anticipated from the qualifications surrounding these definitions, evidence of contagion can only be tested subject to a variety of conditions. These include, first, in the case of pure contagion, news of an event that is independent of what is happening elsewhere. Second, its effects can only be measured after having separated out what would otherwise have happened. For example, the “normal” behavior of the equity value of companies or banks could come from some appropriate first-stage regression, the residuals of which can then be used to test for the effects of contagion by means of a second regression. Third, it may be that there is a need to take account of the ways in which these effects (1) change as a situation evolves, e.g. as a result of a slow release of more and more information and (2) depend on other factors (such as the degree of imperfect competition in an industry, since other firms could benefit from a bankruptcy , or the size of a bank, because regulatory authorities are less likely to allow large banks to go to the wall).


Perhaps somewhat surprisingly, given the many instances in the literature of a temptation to presume that contagion is nothing unusual, most empirical studies have found against it having any substantial or lasting effect. The re is also considerable evidence that it has become increasingly less likely as a result of better provision of information flows specific to individual companies, banks, and countries as well as other changes that help markets to adjust prices more quickly and reliably, such a s, in the wake of the crisis following Mexico’s 1982 problems, secondary markets for sovereign debt.

Examples of statistical studies relating to banking, industry and sovereign loans can be seen in Aharony and Swary (1983), Lang and Stulz (1992), and Musumeci and Sinkey (1990), while Park (1991) reviews evidence of how U S bank panics over the period 1873-1933, far from being a “mysterious” market irrationality, were increasingly subdued by the provision of more and more bank-specific information.

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