Financial Market Structure and Risk Concentration

Abstract

We propose a framework that jointly determines bilateral trading networks and risk allocation between banks. Banks use their bilateral connections to share and concentrate their exposures to idiosyncratic risks. Even when banks are ex-ante homogeneous and risk-averse, they may take risks collectively by concentrating risks on a small set of banks. A structural shift in the market structure in response to a small change in fundamentals and regulations is possible, causing discontinuous changes in aggregate risks and transaction prices. The framework is useful for deriving implications of financial market structure on asset price and bank size distribution and evaluating the responses of the market structure to regulations.

Keywords: Network, Over-the-Counter Market, Regulations

JEL Classification: C70, G1, G20