Credit Risk Transfer and Contagion

34 Pages Posted: 24 Oct 2005

See all articles by Franklin Allen

Franklin Allen

Imperial College London

Elena Carletti

Bocconi University - Department of Finance; European University Institute - Robert Schuman Centre for Advanced Studies (RSCAS)

Date Written: November 24, 2005

Abstract

Some have argued that recent increases in credit risk transfer are desirable because they improve the diversification of risk. Others have suggested that they may be undesirable if they increase the risk of financial crises. Using a model with banking and insurance sectors, we show that credit risk transfer can be beneficial when banks face uniform demand for liquidity. However, when they face idiosyncratic liquidity risk and hedge this risk in an interbank market, credit risk transfer can be detrimental to welfare. It can lead to contagion between the two sectors and increase the risk of crises.

Keywords: Financial innovation, Pareto inferior, banking, insurance

JEL Classification: G21, G22

Suggested Citation

Allen, Franklin and Carletti, Elena, Credit Risk Transfer and Contagion (November 24, 2005). CFS Working Paper No. 2005/25. Available at SSRN: https://ssrn.com/abstract=824226 or http://dx.doi.org/10.2139/ssrn.824226

Franklin Allen (Contact Author)

Imperial College London ( email )

South Kensington Campus
Exhibition Road
London, Greater London SW7 2AZ
United Kingdom

Elena Carletti

Bocconi University - Department of Finance ( email )

Via Roentgen 1
Milano, MI 20136
Italy

European University Institute - Robert Schuman Centre for Advanced Studies (RSCAS) ( email )

Villa La Fonte, via delle Fontanelle 18
50016 San Domenico di Fiesole
Florence, Florence 50014
Italy

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