Entangled Financial Systems
I model an entangled financial system in which banks hedge their portfolio risks using over-the-counter (OTC) contracts. However, banks choose not to hedge counterparty risk, and thus the idiosyncratic failure of a bank can lead to a systemic run of lenders. An inefficiency arises because banks engage in a version of risk shifting through the network externalities created by OTC contracts. Banks do not take into account that the costly hedging of low-probability counterparty risk also benefits other banks. In the model, it is welfare improving to tax OTC contracts to finance a bailout fund. The Author 2013. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: [email protected]., Oxford University Press.
- DOI
- 10.1093/rfs/hht008
- Volume
- 26 (5)
- Pages
- 1291-1323
- Language
- en
- Export
- BibTeX
- Sources
- openalex crossref