Abstract: We offer a theory of financial contagion based on the information choice of investors after observing a financial crisis elsewhere. We study global coordination games of regime change in two regions linked by an initially unobserved macro shock. A crisis in region 1 is a wake-up call to investors in region 2. It induces them to reassess the regional fundamental and acquire information about the macro shock. Contagion can occur even after investors learn that region 2 has no ex-post exposure to region 1. We explore normative and testable implications of the model. In particular, our results rationalize evidence about contagious currency crises and bank runs after wake-up calls and provide some guidance for future empirical work. (D83, F3, G01, G21)
Keywords: wake-up call, information choice, financial crises, contagion, bank run, global games, regime change, fundamental re-assessment.
We propose a novel theory of financial contagion. We study global coordination games of regime change in two regions with an initially uncertain correlation of regional fundamentals. A crisis in region 1 is a wake-up call to investors in region 2 that induces a re-assessment of local fundamentals. Contagion after a wake-up call can occur even if investors learn that fundamentals are uncorrelated and common lender effects or balance sheet linkages are absent. Applicable to currency attacks, bank runs, and debt crises, our theory of contagion is supported by existing evidence and generates a new testable implication for empirical work. (JEL D82, F3, G01)