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Correlated Default and Financial Intermediation

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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, 2015. "Correlated Default and Financial Intermediation," Department of Economics Working Papers 2015-01, Department of Economics, Williams College, revised Sep 2016.
    • Handle: RePEc:wil:wileco:2015-01
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    Keywords

    Financial intermediation; systemic risk; default;
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