Financial Contagion and Lehman Brothers’ Bankruptcy

The bankruptcy of Lehman Brothers provides a unique opportunity to distinguish between two financial contagion channels, common factors or counterparty exposures. We examine three groups of firms, (1) firms making voluntary disclosures of their exposure to Lehman, (2) firms making voluntary disclosures of no exposure to Lehman and (3) firms with claims against Lehman that were not initially disclosed. Firms disclosing material exposures to Lehman suffer large negative industry-adjusted abnormal stock returns around their disclosure announcement, demonstrating that counterparty risk is a significant channel of financial contagion. We also find wide differences in disclosures decisions; these do not seem driven by concerns for litigation or reputation but rather by concerns about contagion. In terms of policy implications, these results support the view that allowing the failure of large financial institutions can have far-reaching effects on other firms and that regulators should have a better understanding of interconnections in the financial system.