Intermediation and Voluntary Exposure to (2013)
BibTeX
@MISC{Risk13intermediationand,
author = {Counterparty Risk and Maryam Farboodi},
title = {Intermediation and Voluntary Exposure to},
year = {2013}
}
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Abstract
I develop a model of financial sector in which endogenous intermediation among debt financed banks generates excessive systemic risk. The central idea is to explore the possibility that certain financial institutions are able to use their lending and borrowing decisions to tilt the division of surplus in their own favor through capturing intermediation spreads, even if the implied change in the structure of financial system hurts the total surplus of the economy. The paper predicts that there is excessive connection among banks who make risky investments and too little connection among those who mainly provide funding. Inefficiency arises because the financial institutions who intermediate among other institutions are exposed to excessive counterparty risk: replacing them with certain other banks mitigates the extent of failure when it is inevitable without hurting the optimal level of investment. In equilibrium, intermediators choose to over expose themselves to other risky banks and suffer the cost of failure due to contagion if they absorb enough rents when they survive.
Keyphrases
voluntary exposure certain financial institution borrowing decision financial institution excessive connection excessive counterparty risk bank generates excessive systemic risk risky bank little connection implied change certain bank financial sector financial system optimal level endogenous intermediation total surplus central idea intermediation spread risky investment enough rent
