Intermediation and Voluntary Exposure to Counterparty Risk

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 coreperiphery network -few highly interconnected and many sparsely connected banksendogenously 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. * I am extremely grateful to my advisors Douglas Diamond, Lars Hansen, Zhiguo He and Raghuram Rajan for their invaluable input. I am grateful to Alex Frankel, Amin Jafarian and Amit Seru for very helpful comments and suggestions. I would also like to thank

A Network View on Interbank Market Freezes

“…The network view on the interbank market we take in this paper provides empirical guidance for the literature that studies the formation and efficiency of interbank networks (see, for example Gofman (2011) andFarboodi (2014)). The endogenous network formation models of Leitner (2005) and Brusco and Castiglionesi (2007) study the trade-off between the completeness of the network, hence the degree of mutual insurance against uncertain liquidity needs due to having a large number of trading counterparties, and the risk of contagion.…”

A dynamic network model of the unsecured interbank lending market

“…The literature, however, lacks a model of peer monitoring at the bank-to-bank level in an OTC market. 6 Second, our paper is related to the growing literature on how financial networks are formed (see, for example, Gale and Kariv 2007;in 't Veld, van der Leij, and Hommes 2014;Vuillemey and Breton 2014;and Farboodi 2014). 7 In particular, shows that when agents trade risky assets over-the-counter, asymmetric information and costly link formation can endogenously lead to an undirected star network with just one intermediary.…”

“…7 In particular, shows that when agents trade risky assets over-the-counter, asymmetric information and costly link formation can endogenously lead to an undirected star network with just one intermediary. Farboodi (2014) develops a model that generates a core-periphery structure in which banks try to capture intermediation rents. Crucially, her model relies on the assumption that there are differences in investment opportunities (see also in 't Veld, van der Leij, and Hommes 2014).…”

The Formation of a Core-Periphery Structure in Heterogeneous Financial Networks

“…One may make a distinction between papers that are more concerned with the trade offs between contagion, risk sharing, efficiency and stability (Cabrales et al, 2013;Acemoglu et al, 2014;Babus, 2016), and papers that (among other things) rationalise the formation of a core-periphery structure in financial networks (Farboodi, 2015;Bedayo et al, 2016;Castiglionesi and Navarro, 2016;Chang and Zhang, 2016;Wang, 2016). Our paper belongs to the second category.…”

“…In Farboodi (2015) banks are heterogeneous in their investment opportunities, and they compete for intermediation benefits. A core-periphery network is formed with investment banks forming the core, as they are able to offer better intermediation rates.…”