Do Financial Markets Expect Bank Defaults to Be Contagious?

Abstract

Simultaneous bank defaults are often attributed to interbank contagion, but can also be due to common shocks affecting banks with similar balance sheets. We disentangle both effects by realising that if financial markets expect a bank's default to be contagious, an increase in this bank's default probability should lower other banks' market valuations. When we regress changes in banks' market values on changes in other banks' default probabilities for the 2007-2009 financial crisis, we find no evidence for such an effect. This finding suggests that contagion risk has been overestimated, which has implications for financial regulation and crisis management.