Information Contagion and Systemic Risk

We examine the effect of ex-post information contagion on the ex-ante level of systemic risk defined as the probability of joint bank default. Because of counterparty risk or common exposures, bad news about one bank reveals valuable information about another bank, triggering information contagion. When banks are subject to common exposures, information contagion induces small adjustments to bank portfolios and therefore increases overall systemic risk. When banks are subject to counterparty risk, by contrast, information contagion induces a large shift toward more prudential portfolios, thereby reducing systemic risk.