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

It was presently found that a credit for money deposited in the Cham- ber was quite equivalent to so much cash in band; and the custom was introduced of effecting payments by the transfer of these credits from the account of the payer to that of the receiver. In this way the trouble of counting large sums of coin, and of transporting it from one part of the city to another, was wholly avoided. So great were the supposed advan- tages of this method of doing business, that what at first had been vol- untary on the part of the merchants, was afterwards enforced by law. Every merchant. | Information Contagion and Inter-Bank Correlation in a Theory of Systemic Risk1 Viral V. Acharya2 London Business School and CEPR Tanju Yorulmazer3 New York University . Classification G21 G28 G38 E58 D62. Keywords Systemic risk Contagion Herding Procyclicality Information spillover Inter-bank correlation First Draft September 15 2002 This Draft December 21 2002 1We are grateful to Franklin Allen and Douglas Gale for their encouragement and advice to Luigi Zingales for suggesting that the channel of information spillovers be examined as a source of systemic risk to Amil Dasgupta John Moore and seminar participants at Bank of England Corporate Finance Workshop - London School of Economics London Business School Department of Economics - New York University and Financial Crises Workshop conducted by Franklin Allen at Stern School of Business - New York University for useful comments and to Nancy Kleinrock for editorial assistance. All errors remain our own. 2Contact Department of Finance London Business School Regent s Park London -NW1 4SA England. Tel 44 0 20 7262 5050 Fax 44 0 20 7724 3317 e-mail vacharya@. Acharya is also a Research Affiliate of the Centre for Economic Policy Research CEPR . 3Contact . candidate Department of Economics New York University 269 Mercer St. New York NY - 10003. Tel 212 998 8909 Fax 212 995 4186 e-mail ty232@ Information Contagion and Inter-Bank Correlation in a Theory of Systemic Risk Abstract 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 .

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