Credit Risk Transfer and Contagion
34 Pages Posted: 24 Oct 2005
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: Suggested Citation
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