Information Contagion and Bank Herding

Authors


  • This paper is a revised version of a chapter of Tanju Yorulmazer's Ph.D. dissertation at the Department of Economics, New York University, and is a shorter and generalized version of the paper circulated under the title “Limited Liability and Bank Herding.” We are grateful to Franklin Allen and Douglas Gale for their encouragement and advice; to Sudipto Bhattacharya, Amil Dasgupta, Phillip Hartmann, Alessandro Lizzeri, Deborah Lucas (editor), John Moore, George Pennacchi, Enrico Perotti, Andrew Schotter, Raghu Sundaram, Anjan Thakor, Bent Vale, Andy Winton, two anonymous referees, and seminar participants at Bank of Canada, Bank of England, Bank for International Settlements, Center for Economic Policy Research (CEPR) Conference on “Financial Stability and Monetary Policy,” Conference on “Liquidity Concepts and Financial Instabilities” at the Center for Financial Studies at Eltville, Corporate Finance Workshop-London School of Economics, Department of Economics-New York University, European Finance Association Meetings in 2004, Federal Deposit Insurance Corporation (FDIC) Conference on “Finance and Banking: New Perspectives,” Financial Crises Workshop conducted by Franklin Allen at Stern School of Business-New York University, International Monetary Fund, and London Business School, for useful comments; and to Nancy Kleinrock for editorial assistance. All errors remain our own. The views expressed here are those of the authors and do not necessarily reflect those of the Federal Reserve Bank of New York or the Federal Reserve System.

Abstract

We show that the likelihood of information contagion induces profit-maximizing bank owners to herd with other banks. When bank loan returns have a common systematic factor, the cost of borrowing for a bank increases when there is adverse news on other banks since such news conveys adverse information about the common factor. The increase in a bank's cost of borrowing relative to the situation of good news about other banks is greater when bank loan returns have less commonality (in addition to the systematic risk factor). Hence, banks herd and undertake correlated investments so as to minimize the impact of such information contagion on the expected cost of borrowing. Competitive effects such as superior margins from lending in different industries mitigate herding incentives.

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