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Correlated Default and Financial Intermediation

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  • GREGORY PHELAN

Abstract

Financial intermediation naturally arises when knowledge about the aggregate state is valuable for managing investments and lenders cannot easily observe the aggregate state. I show this using a costly enforcement model in which lenders need ex-post incentives to enforce payments from defaulted loans and borrowers' payoffs are correlated. When projects have correlated outcomes, learning the state of one project (via enforcement) provides information about the states of other projects. A large, correlated portfolio provides ex-post incentives for enforcement; as a result, intermediation dominates direct lending, intermediaries are financed with risk-free deposits, earn positive profits, and hold systemic default risk.
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  • Gregory Phelan, 2017. "Correlated Default and Financial Intermediation," Journal of Finance, American Finance Association, vol. 72(3), pages 1253-1284, June.
    • Handle: RePEc:bla:jfinan:v:72:y:2017:i:3:p:1253-1284
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    2. Javadi, Siamak & Mollagholamali, Mohsen, 2018. "Debt market illiquidity and correlated default risk," Finance Research Letters, Elsevier, vol. 26(C), pages 266-273.
    3. André F. Silva, 2019. "Strategic Liquidity Mismatch and Financial Sector Stability," Finance and Economics Discussion Series 2019-082, Board of Governors of the Federal Reserve System (U.S.).
    4. Pedro Manuel Nogueira Reis & António Pedro Soares Pinto, 2022. "How Do Banking Characteristics Influence Companies’ Debt Features and Performance during COVID-19? A Study of Portuguese Firms," IJFS, MDPI, vol. 10(4), pages 1-29, October.
    5. Anna Maria C. Menichini & Peter J. Simmons, 2017. "Efficient audits by pooling projects," Discussion Papers 17/19, Department of Economics, University of York.
    6. Yildirim, Alev, 2020. "The effect of relationship banking on firm efficiency and default risk," Journal of Corporate Finance, Elsevier, vol. 65(C).
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