Counterparty Choice, Bank Interconnectedness, and Systemic Risk

77 Pages Posted: 16 Jul 2021

See all articles by Andrew Ellul

Andrew Ellul

Indiana University - Kelley School of Business - Department of Finance; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI); University of Naples Federico II - CSEF - Center for Studies in Economics and Finance

Dasol Kim

Office of Financial Research, US Department of the Treasury

Date Written: July 14, 2021

Abstract

We provide evidence on how banks form network connections and endogenous risk-taking in their non-bank counterparty choices in the OTC derivative markets. We use confidential regulatory data from the Capital Assessment and Stress Testing reports that provide counterparty-level data across a wide range of OTC markets for the most systemically important U.S. banks. We show that banks are more likely to either establish or maintain a relationship, and increase their exposures within an existing relationship, with non-bank counterparties that are already heavily connected and exposed to other banks. Banks in such densely-connected networks are more likely to connect with riskier counterparties for their most material exposures. The effects are strongest in the case of (non-bank) financial counterparties. These findings suggest moral hazard behavior in counterparty choices. Finally, we demonstrate that these exposures are strongly linked to systemic risk. Overall, the results suggest a network formation process that amplifies risk propagation through non-bank linkages in opaque financial markets.

Keywords: Counterparty risk, financial networks, bank interconnectedness, over-the-counter markets, derivatives

JEL Classification: G21, G22, D82

Suggested Citation

Ellul, Andrew and Kim, Dasol, Counterparty Choice, Bank Interconnectedness, and Systemic Risk (July 14, 2021). Available at SSRN: https://ssrn.com/abstract=3886985 or http://dx.doi.org/10.2139/ssrn.3886985

Andrew Ellul (Contact Author)

Indiana University - Kelley School of Business - Department of Finance ( email )

1309 E. 10th St.
Bloomington, IN 47405
United States

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

University of Naples Federico II - CSEF - Center for Studies in Economics and Finance ( email )

Via Cintia
Complesso Monte S. Angelo
Naples, Naples 80126
Italy

Dasol Kim

Office of Financial Research, US Department of the Treasury ( email )

717 14th Street, NW
Washington, DC 20220
United States

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