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Intermediation and Voluntary Exposure to Counterparty Risk

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  • Maryam Farboodi

Abstract

I study a model of the financial sector in which intermediation among debt financed banks gives rise to an endogenous core-periphery network – few highly interconnected and many sparsely connected banks. Endogenous intermediation generates excessive systemic risk in the financial network. 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. 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.

Suggested Citation

  • Maryam Farboodi, 2021. "Intermediation and Voluntary Exposure to Counterparty Risk," NBER Working Papers 29467, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:29467
    Note: CF
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    Cited by:

    1. Babus, Ana & Hachem, Kinda, 2023. "Markets for financial innovation," Journal of Economic Theory, Elsevier, vol. 208(C).
    2. Di Xiao & Andreas Krause, 2023. "Balancing liquidity and returns through interbank markets: Endogenous interest rates and network structures," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 46(1), pages 131-149, February.
    3. Agathe Sadeghi & Zachary Feinstein, 2024. "Statistical Validation of Contagion Centrality in Financial Networks," Papers 2404.14337, arXiv.org.
    4. Xue Cui & Lu Yang, 2024. "Systemic risk and idiosyncratic networks among global systemically important banks," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 29(1), pages 58-75, January.
    5. Daniel E. Rigobon & Ronnie Sircar, 2022. "Formation of Optimal Interbank Networks under Liquidity Shocks," Papers 2211.12404, arXiv.org, revised Oct 2024.
    6. Mario Eboli & Bulent Ozel & Andrea Teglio & Andrea Toto, 2023. "Connectivity, centralisation and ‘robustness-yet-fragility’ of interbank networks," Annals of Finance, Springer, vol. 19(2), pages 169-200, June.

    More about this item

    JEL classification:

    • D85 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Network Formation
    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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