Intermediation and Voluntary Exposure to Counterparty Risk

60 Pages Posted: 14 Dec 2014

See all articles by Maryam Farboodi

Maryam Farboodi

Princeton University - Bendheim Center for Finance

Date Written: August 1, 2014

Abstract

I develop a model of the financial sector in which endogenous intermediation among debt financed banks generates excessive systemic risk. Financial institutions have incentives to capture intermediation spreads through strategic borrowing and lending decisions. By doing so, they tilt the division of surplus along an intermediation chain in their favor, while at the same time reducing aggregate surplus. I show that a core-periphery network – few highly interconnected and many sparsely connected banks – endogenously emerges in my model. The network is inefficient relative to a constrained efficient benchmark since banks who make risky investments "overconnect", exposing themselves to excessive counterparty risk, while banks who mainly provide funding end up with too few connections. The predictions of the model are consistent with empirical evidence in the literature.

Keywords: Intermediation, Counterpart risk, financial network, network formation, banking, core-periphery, systemic risk, stability

JEL Classification: G01, D85

Suggested Citation

Farboodi, Maryam, Intermediation and Voluntary Exposure to Counterparty Risk (August 1, 2014). Available at SSRN: https://ssrn.com/abstract=2535900 or http://dx.doi.org/10.2139/ssrn.2535900

Maryam Farboodi (Contact Author)

Princeton University - Bendheim Center for Finance ( email )

26 Prospect Avenue
Princeton, NJ 08540
United States

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
407
Abstract Views
1,963
rank
106,741
PlumX Metrics