Entangled Financial Systems
Review of Financial Studies (2013), vol. 26(1), 1291-1323
50 Pages Posted: 22 Feb 2011 Last revised: 8 Oct 2013
Date Written: November 4, 2011
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: Suggested Citation