Entangled Financial Systems

Review of Financial Studies (2013), vol. 26(1), 1291-1323

Boston U. School of Management Research Paper No. 2011-2

50 Pages Posted: 22 Feb 2011 Last revised: 8 Oct 2013

See all articles by Adam Zawadowski

Adam Zawadowski

Boston University - Department of Finance & Economics

Date Written: November 4, 2011

Abstract

I model an entangled financial system in which banks hedge their portfolio risks using over-the-counter (OTC) contracts. However, banks choose not to hedge counterparty risk, and thus the idiosyncratic failure of a bank can lead to a systemic run of lenders. An inefficiency arises because banks engage in a version of risk shifting through the network externalities created by OTC contracts. Banks do not take into account that the costly hedging of low-probability counterparty risk also benefits other banks. In the model, it is welfare improving to tax OTC contracts to finance a bailout fund.

Keywords: OTC contracts, credit default swaps, financial stability

JEL Classification: G21, G28, G12

Suggested Citation

Zawadowski, Adam, Entangled Financial Systems (November 4, 2011). Review of Financial Studies (2013), vol. 26(1), 1291-1323; Boston U. School of Management Research Paper No. 2011-2. Available at SSRN: https://ssrn.com/abstract=1765993 or http://dx.doi.org/10.2139/ssrn.1765993

Adam Zawadowski (Contact Author)

Boston University - Department of Finance & Economics ( email )

595 Commonwealth Avenue
Boston, MA 02215
United States

HOME PAGE: http://people.bu.edu/zawa

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