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

The largely unanticipated bankruptcy of Lehman Brothers and firms’ voluntary disclosures of their exposures to Lehman in the aftermath of the bankruptcy provide a clean laboratory to test counterparty risk contagion, information transmission channel and other competing contagion theories. Using market microstructure variables that measure trading activities including number of trade, trade size, and trade volume, and liquidity conditions including transaction cost, price impact of trade, adverse selection cost, and buy-sell order imbalance, we thoroughly examine negative consequences of contagion effects. Overall, the evidence supports the dominant role for the counterparty contagion hypothesis – firms with exposure to Lehman suffered severe negative effects measured by greater price impact, information asymmetry, selling pressure and negative returns. The evidence on the information transmission hypothesis is mixed – firms that announced that they had no exposure to Lehman also experienced increase in transaction cost, but no significant increase in price impact, information asymmetry and selling pressure. We find no consistent evidence supporting the ‘flight to quality’ or ‘flight from liquidity’ hypotheses as contagion channels.