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Abstract

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.

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... Note that, whereas hedging demand is naturally related to insurable interest, there is no reason to believe that speculative trading activity (i.e., bets on future changes in credit quality) in the CDS market should be directly related to insurable interest. 2 More broadly, our paper relates to a growing literature that investigates the effects of CDS markets on information transmission, risk transfer, and credit market outcomes (Acharya and Johnson 2007;Qiu and Yu 2012;Minton, Stulz, and Williamson 2009;Ashcraft and Santos 2009;Hirtle 2009;Saretto and Tookes 2013), as well as a growing theory literature on the uses of CDSs (Duffee and Zhou 2001;Parlour and Plantin 2008;Thompson 2009;Parlour and Winton 2013;Bolton and Oehmke 2011;Zawadowski 2013;Atkeson, Eisfeldt, and Weill 2015;Che and Sethi 2014;Fostel and Geanakoplos 2012;Oehmke and Zawadowski 2015). Du and Zhu (2013), Gupta and Sundaram (2012), and Chernov, Gorbenko, and Makarov (2013) investigate CDS settlement auctions. ...
... 13 Second, the large positive and statistically significant coefficient on the dummy variable credit enhancement in Column (4) reflects a large amount of net notional CDS protection written on companies that provide credit enhancement (e.g., monoline insurers): firms that provide credit enhancement on average have an additional $2 bn in net notional CDS positions. 14 This suggests that investors who rely on insurance from monoline insurance companies and other providers of credit enhancement purchase CDSs to eliminate counterparty risk, as in Zawadowski (2013). In these cases, the protection provided by credit enhancement firms represents an insurable interest that purchasers of this insurance may want to hedge in the CDS market. ...
Article
Using novel position and trading data for single-name corporate credit default swaps (CDSs), we provide evidence that CDS markets emerge as “alternative trading venues” serving a standardization and liquidity role. CDS positions and trading volume are larger for firms with bonds fragmented into many separate issues and with heterogeneous contractual terms. Whereas hedging motives are associated with trading volume in the bond and CDS markets, speculative trading concentrates in the CDS. Cross-market arbitrage links the CDS and bond market via the basis trade, compressing the negative CDS-bond basis and reducing price impact in the bond market. Received September 24, 2014; accepted January 17, 2016 by Editor Andrew Karolyi.
... Acemoglu et al. (2013) also discusses network formation, within a set of limited alternatives. Zawadowski (2013) models the decision of agents to purchase default insurance on their counter-parties. This can be interpreted as a model of network formation, but it is not a model of an agent choosing a particular counter-party because the counter-parties are fixed. ...
... Rochet and Tirole (1996a) can be seen as an example, comparing the efficacy of different payment systems. 11 Such as Babus (2013), Babus and Hu (2015), Blume et al. (2013), Chang and Zhang (2015), Condorelli and Galeotti (2015), Kiyotaki and Moore (1997), Lagunoff and Schreft (2001), Moore (2011), Wang (2014), Zawadowski (2013). consider the possibility that the anticipation of ex-post government intervention might affect the network. ...
Article
In the aftermath of the financial crisis of 2008, many policy makers and researchers pointed to the interconnectedness of the financial system as one of the fundamental contributors to systemic risk. The argument is that the linkages between financial institutions served as an amplification mechanism: shocks to smaller parts of the system propagate through the system and result in broad damage to the financial system. In my dissertation, I explore the formation of networks when agents take into account systemic risk. The dissertation consists of three complementary papers on this topic. The first paper titled ``Network Formation and Systemic Risk'', joint with Professor Rakesh Vohra. We set out the framework and construct a model of endogenous network formation and systemic risk. We find that fundamentally `safer' economies with higher probability of getting good shocks generate higher interconnectedness, which leads to higher systemic risk. This provides network foundations for ``the volatility paradox'' arguing that better fundamentals lead to worse outcomes due to excessive risk taking. Second, the network formed crucially depends on the correlation of shocks to the system. As a consequence, an observer, such as a regulator, facing an interconnected network who is mistaken about the correlation structure of shocks will underestimate the probability of system wide failure. This result relates to the ``dominoes vs. popcorn'' discussion by Edward Lazear. He comments that a fundamental mistake in addressing the crisis was to think that it was ``dominoes'' so that saving one firm would save many others in the line. He continues to argue that it was ``popcorn in a pan'': all firms were exposed to same correlated risks and saving one would not save many others. We complement his discussion by arguing that the same mistake might have been the reason behind why sufficient regulatory precaution was not taken prior to the crisis. The third result is that the networks formed in the model are utilitarian efficient because the risk of contagion is high. This causes firms to minimize contagion by forming dense but isolated clusters that serve as firebreaks. This finding is suggestive that, the worse the contagion, the more the market takes care of it. In the second paper, titled ``Network Hazard and Bailouts'', I ask how the anticipation of ex-post government bailouts affects network formation. I deploy a significant generalization of the model in the first paper and allow for time-consistent government transfers. I find that the presence of government bailouts introduces a novel channel for moral hazard via its effect on network architecture, which I call ``network hazard''. In the absence of bailouts, firms form sparsely connected small clusters in order to eliminate second-order counterparty risk: expected losses due to defaulting counterparties that default because of their own defaulting counterparties. Bailouts, however, eliminate second-order counterparty risk already. Accordingly, when bailouts are anticipated, the networks formed become more interconnected, and exhibit a core-periphery structure (many firms connected to a smaller number of central firms, which is observed in practice). Interconnectedness within the periphery leads to higher extent of contagion with respect to the networks formed in the absence of intervention. Moreover, solvent core firms serve as a buffer against contagion by increasing the resilience of the many peripheral firms that are connected to the core. However, insolvent core firms serve as an amplifier of contagion since they make peripheral firms less resilient. This implies that in my model, ex-post time-consistent intervention by the government, while ex-ante welfare improving, increases systemic risk and volatility, solely through its effect on the network. A remark is that firms, in my model, do not make riskier individual choices regarding neither their choice of investment risk, nor the number of their counterparties they have. In this sense, network hazard is a genuine form of moral hazard solely through the formation of the detailed network. On another note, the model can also be viewed as a first attempt towards developing a theory of mechanism design with endogenously formed network externalities which might be useful in various other scenarios such as provision of local public goods. In the final paper, titled “Network Reactions to Banking Regulations”, joint with Professor Guilermo Ordonez, we consider the role of liquidity and capital requirements to alleviate network hazard and systemic risk. In the model, financial firms set up credit lines with each other in order to meet their funding needs on demand. Accordingly, higher liquidity requirements induce firms to form higher interconnectedness in order to be able to find deposits as needed. At a tipping point of liquidity requirements, the network discontinuously jumps in its interconnectedness, which contributes discontinuously to systemic risk. On the other hand, the reaction to capital requirements is smooth. Capital requirements indirectly work as an upper bound in the interconnectedness firms would form. This way, interconnectedness can be effectively reduced to a desired level via capital requirements. Yet capital requirements cannot be used to induce higher interconnectedness. Thusly, in times of credit freeze, capital requirements may not help promote circulation of credit. A conjunction of both liquidity and capital requirements is more effective in promoting desired circulation while reducing systemic risk. The work in this dissertation suggests that endogenous network architecture is an essential component of the study of financial markets. In particular, network hazard is a genuine form of moral hazard that will be overlooked unless network formation is taken into account, while it has implications about systemic risk. Moreover, this work illustrates how the reaction of networked financial markets to both fundamentals of the economy and to the policy can be non-trivial, featuring non-monotonicity and discontinuity.
... The two-trader case is of special interest, mainly because the large majority of risk-sharing transactions are bilateral between large institutions and/or their clients or brokers; related discussions and statistics are provided in [BH16,Bab16,DSV15,Zaw13,HM15]. We obtain explicit expressions for two-trader price-allocation noncompetitive equilibria, which allow us to analyse further the model's economic insight. ...
Preprint
We consider thin incomplete financial markets, where traders with heterogeneous preferences and risk exposures have motive to behave strategically regarding the demand schedules they submit, thereby impacting prices and allocations. We argue that traders relatively more exposed to market risk tend to submit more elastic demand functions. Noncompetitive equilibrium prices and allocations result as an outcome of a game among traders. General sufficient conditions for existence and uniqueness of such equilibrium are provided, with an extensive analysis of two-trader transactions. Even though strategic behaviour causes inefficient social allocations, traders with sufficiently high risk tolerance and/or large initial exposure to market risk obtain more utility gain in the noncompetitive equilibrium, when compared to the competitive one.
... While some work has studied the formation of financial networks (e.g. Farboodi (2014); Zawadowski (2013); Babus (2016); Anufriev et al. (2016)), less work has been devoted to controlling the incentives that institutions (e.g. banks) may have to form a resilient network. ...
Preprint
When banks extend loans to each other, they generate a negative externality in the form of systemic risk. They create a network of interbank exposures by which they expose other banks to potential insolvency cascades. In this paper, we show how a regulator can use information about the financial network to devise a transaction-specific tax based on a network centrality measure that captures systemic importance. Since different transactions have different impact on creating systemic risk, they are taxed differently. We call this tax a Systemic Risk Tax (SRT). We use an equilibrium concept inspired by the matching markets literature to show analytically that this SRT induces a unique equilibrium matching of lenders and borrowers that is systemic-risk efficient, i.e. it minimizes systemic risk given a certain transaction volume. On the other hand, we show that without this SRT multiple equilibrium matchings exist, which are generally inefficient. This allows the regulator to effectively stimulate a `rewiring' of the equilibrium interbank network so as to make it more resilient to insolvency cascades, without sacrificing transaction volume. Moreover, we show that a standard financial transaction tax (e.g. a Tobin-like tax) has no impact on reshaping the equilibrium financial network because it taxes all transactions indiscriminately. A Tobin-like tax is indeed shown to have a limited effect on reducing systemic risk while it decreases transaction volume.
... Blume, Easley, Kleinberg, and Kleinberg (2013) modelled interbank contagion as an epidemic. Zawadowski (2013) proposed a model of an entangled financial system in which banks hedge their portfolio risk using over-the-counter (OTC) contracts. The author argues that inefficiency arises when banks shift risk through the network externalities created by OTC contracts. ...
Article
A R T I C L E I N F O JEL classification: C58 F36 G11 G21 R10 Keywords: Banking sector Network Spillover index Portfolio optimization and diversification Americas A B S T R A C T We examine the network spillovers, portfolio allocation characteristics and diversification potential of bank returns from developed and emerging America. We draw our results by applying a directional spillover index, the tail-event driven network (TENET) and nonlinear portfolio optimization methods on bank returns. We find that the spillovers and connectedness among banks from emerging America are noticeably smaller than those among banks from developed America. The largest emerging market spillover transmitters and receivers are the banks from Brazil, followed by the banks from Chile. The largest developed market spillover transmitter is JP Morgan Chase. The connectedness among banks from developed America is dominated by the banks from the USA, relative to those from Canada. The total connectedness of the emerging market banks is more intensified than that of the banks from developed America due to the effect of the COVID-19 pandemic. The portfolio optimization shows that in developed America, the largest banks from the USA are the largest risk contributors to total portfolio risk, whereas the banks from Canada contribute the least risk. In emerging America, the banks from Brazil contribute the most risk to total portfolio risk while the banks from Peru and one bank from Colombia contribute the least risk. The portfolio of banks from emerging America offers greater diversification potential and lower total portfolio allocation risk.
... Blume, Easley, Kleinberg, and Kleinberg (2013) modelled interbank contagion as an epidemic. Zawadowski (2013) proposed a model of an entangled financial system in which banks hedge their portfolio risk using over-the-counter (OTC) contracts. The author argues that inefficiency arises when banks shift risk through the network externalities created by OTC contracts. ...
Article
A R T I C L E I N F O JEL classification: C58 F36 G11 G21 R10 Keywords: Banking sector Network Spillover index Portfolio optimization and diversification Americas A B S T R A C T We examine the network spillovers, portfolio allocation characteristics and diversification potential of bank returns from developed and emerging America. We draw our results by applying a directional spillover index, the tail-event driven network (TENET) and nonlinear portfolio optimization methods on bank returns. We find that the spillovers and connectedness among banks from emerging America are noticeably smaller than those among banks from developed America. The largest emerging market spillover transmitters and receivers are the banks from Brazil, followed by the banks from Chile. The largest developed market spillover transmitter is JP Morgan Chase. The connectedness among banks from developed America is dominated by the banks from the USA, relative to those from Canada. The total connectedness of the emerging market banks is more intensified than that of the banks from developed America due to the effect of the COVID-19 pandemic. The portfolio optimization shows that in developed America, the largest banks from the USA are the largest risk contributors to total portfolio risk, whereas the banks from Canada contribute the least risk. In emerging America, the banks from Brazil contribute the most risk to total portfolio risk while the banks from Peru and one bank from Colombia contribute the least risk. The portfolio of banks from emerging America offers greater diversification potential and lower total portfolio allocation risk.
... Based on the pricing of interbank liabilities Eisenberg and Noe (2001) and the study of private "bailouts" (Leitner 2005), authors report that some banks voluntarily expose themselves to contagion, while too dense interconnections (Gai andKapadia 2010, Acemoglu et al. 2015) and specifically shaped networks (Castiglionesi and Navarro 2011, Anand et al. 2013, Babus and Hu 2017, Farboodi 2021, Babus 2016) serve as a mechanism for the propagation of shocks. Zawadowski (2013) shows that unhedged counterparty risk in the interbank markets may lead to bank runs, while Afonso and Shin (2011), Zhu (2011), Koeppl, Monnet andTemzelides (2012), Acharya and Bisin (2014) and Duffie (2014) all argue that central counterparties (CCPs) in the OTC markets may be effective in preventing illiquidity spillovers if designed and implemented in certain ways. ...
Article
Full-text available
We investigate if all European IBOR rates are similarly susceptibile to turbulence as LIBOR rates. We also analyze systemic risk spillovers between different IBOR rates in Europe and between these rates and the studied banking systems between 2006 and now. We employ a set of innovations in calculating two systemic risk measures: ΔCoVaR and SIM, which enables us to study a large sample of 72 banks that are systemically important for Europe and 19 IBOR term structures, making this paper a comprehensive analysis of Western, Central, and Eastern Europe. We discuss the empirical results in the context of the challenges, risks, and feasibility of a full transition toward the new rates in the CEE region. Conclusions are relevant for market regulators in the investigated region because they apply not only to the IBOR rates in a backward-looking manner but also to the new rates to be adopted in a forward-looking one.
... Duffie and Zhu (2011) analyze netting efficiency for central and bilateral clearing. Leitner (2011), Zawadowski (2013, and Acharya and Bisin (2014) argue that central clearing can reduce counterparty risk externalities. Koeppl, Monnet, and Temzelides (2012) show that a CCP can lower trading costs by deferring settlement and providing credit to clearing members. ...
Article
Full-text available
This article analyzes the optimal allocation of losses via a Central Clearing Counterparty (CCP) in the presence of counterparty risk. A CCP can hedge this risk by mutualizing losses among its members. This protection, however, weakens members’ incentives to manage counterparty risk. Delegating members’ risk monitoring to the CCP alleviates this tension in large markets. To discipline the CCP at minimum cost, members offer the CCP a junior tranche and demand capital contribution. Our results endogenize key layers of the default waterfall and deliver novel predictions on its composition, collateral requirements, and CCP ownership structure.
... We are not aware of any existing comparable econometric study in the literature on networks. We rely on previous theoretical and empirical works on CDS trading (for hedging, see Duffee and Zhou (2001); for managing counterparty risk, see Zawadowski (2013); for trading, see Acharya and Johnson (2007) and Fontana and Scheicher (2010); for regulatory arbitrage, see Yorulmazer (2012) but is also consistent with hedging uses. Furthermore, we document differences in intercept and marginal effects for sovereign names (as compared to financial names), with sign patterns consistent with the use of sovereign CDS for "proxy hedging". ...
Thesis
In its first part, this thesis studies the optimal use of derivatives contracts for risk management by financial intermediaries, focusing especially on interest rate derivative contracts. It models the optimal capital structure policy of a bank and shows how the optimal use of derivatives affects a number of oft-studied decisions in corporate finance: bank lending, maturity mismatching, payout policy or default probabilities. The second part of the thesis, in contrast, studies derivatives market as a system on its own. The second chapter uses a new and unique dataset of bilateral exposures to CDS contracts in order to provide a detailed description of the network structure of exposures. The third chapter focuses on the regulation of derivatives markets. It studies central clearing of standardized derivatives contracts and the collateral demand induced by the reform at a global scale, under a variety of hypotheses regarding the market microstructure.
... Also see Zawadowski[40], Farboodi[27], and Erol[26], who study how endogenous formation of financial networks can shape systemic risk. ...
Article
Full-text available
This paper develops a network model of interbank lending, in which banks decide to extend credit to their potential borrowers. Borrowers are subject to shocks that may force them to default on their loans. In contrast to much of the previous literature on financial networks, we focus on how anticipation of future defaults may result in ex ante “credit freezes,” whereby banks refuse to extend credit to one another. We first characterize the terms of the interbank contracts and the patterns of interbank lending that emerge in equilibrium. We then study how shifts in the distribution of shocks can result in complex credit freezes that travel throughout the network. We use this framework to analyze the effects of various policy interventions on systemic credit freezes.
... Blume, Easley, Kleinberg, and Kleinberg (2013) modelled interbank contagion as an epidemic. Zawadowski (2013) proposed a model of an entangled financial system in which banks hedge their portfolio risk using over-the-counter (OTC) contracts. The author argues that inefficiency arises when banks shift risk through the network externalities created by OTC contracts. ...
Article
We examine the network spillovers, portfolio allocation characteristics and diversification potential of bank returns from developed and emerging America. We draw our results by applying a directional spillover index, the tail-event driven network (TENET) and nonlinear portfolio optimization methods on bank returns. We find that the spillovers and connectedness among banks from emerging America are noticeably smaller than those among banks from developed America. The largest emerging market spillover transmitters and receivers are the banks from Brazil, followed by the banks from Chile. The largest developed market spillover transmitter is JP Morgan Chase. The connectedness among banks from developed America is dominated by the banks from the USA, relative to those from Canada. The total connectedness of the emerging market banks is more intensified than that of the banks from developed America due to the effect of the COVID-19 pandemic. The portfolio optimization shows that in developed America, the largest banks from the USA are the largest risk contributors to total portfolio risk, whereas the banks from Canada contribute the least risk. In emerging America, the banks from Brazil contribute the most risk to total portfolio risk while the banks from Peru and one bank from Colombia contribute the least risk. The portfolio of banks from emerging America offers greater diversification potential and lower total portfolio allocation risk.
... 2. The second category endogenizes network formation in anticipation of possible shocks (e.g., Leitner [2005], Zawadowski [2013], Babus and Hu [2015], Babus [2016], Cabrales et al. [2017], Elliott et al. [2018], and Erol and Vohra [2018]). In our paper, the equity-holding network is fixed exogenously. ...
... The two-trader case is of special interest, mainly because the large majority of risk-sharing transactions are bilateral between large institutions and/or their clients or brokers; related discussions and statistics are provided in [BH16,Bab16,DSV15,Zaw13,HM15]. We obtain explicit expressions for two-trader price-allocation noncompetitive equilibria, which allow us to analyse further the model's economic insight. ...
Article
We consider thin incomplete financial markets, where traders with heterogeneous preferences and risk exposures have motive to behave strategically regarding the demand schedules they submit, thereby impacting prices and allocations. We argue that traders relatively more exposed to the market portfolio tend to behave in a more risk tolerant manner. Noncompetitive equilibrium prices and allocations result as an outcome of a game among traders. General sufficient conditions for existence and uniqueness of such equilibrium are provided, with extensive analysis of two‐trader transactions. Even though strategic behavior causes inefficient social allocations, traders with sufficiently high risk tolerance and/or high initial exposure to tradable securities obtain more utility gain in the noncompetitive equilibrium, when compared to the competitive one.
... Other related papers includeRochet and Tirole (1996),Upper (2007),Kiyotaki et al. (1997), andZawadowski et al. (2013). See also the survey Hasman (2013) on factors for determining contagion in network structure. ...
Article
Full-text available
We consider a financial network where banks are heterogeneous in scale and each bank has only local knowledge regarding the network. Each bank must make counterparty and portfolio decisions while anticipating uncertainty regarding the network structure. Such network uncertainty is an important consideration in banks’ risk management practice, which aims to minimize the effect of exogenous liquidity shocks and hedge against possible fire-sale in asset markets. We show that network uncertainty gives rise to an endogenous core-periphery structure which is optimal in mitigating financial contagion yet concentrates systemic risk at the core of big banks.
... While the theory literature focused mainly on financial network formation from credit lending which can create systemic crisis due to a sequence of counterparty risk exposure (e.g. Farboodi (2017), Babus (2016, Acemoglu et al (2015), Zawadowski (2013)), a small literature discussed systemic risk from common asset holdings (e.g. Wagner (2008Wagner ( , 2010, Raffestin (2014)). ...
Thesis
This thesis contains three chapters discussing different aspects of financial markets. The first chapter studies the impact of learning information about future non-fundamental shocks on stock price dynamics and provides a new insight into how rational speculators can cause inefficiency and volatility to stock markets during periods of information technology advancement. I construct an infinite-period competitive market model and analyze how an increase in non-fundamental signal precision affects trading strategy of rational investors, price formation, and efficiency. Contradicting to traditional rational speculative theory, I found that higher non-fundamental signal precision can increase stock return volatility, increase price sensitivity to both current and future non-fundamental shocks, and decrease price informativeness. Moreover, even though investors have better information about future stock prices, they can predict stock returns less accurately. This is because the investors expect that their future counterparts will also trade more aggressively on new non-fundamental information that arrives in the future, causing future stock prices to be endogenously more volatile to new non-fundamental shocks which are unpredictable to the investors at the present. The second chapter develops a game-theoretic dynamic model to study strategic dealer choice of buy-side investors in over-the-counter (OTC) secondary asset markets and provides a new theory of why periphery dealers, despite locating at inferior positions in OTC dealer network, can survive and co-exist with core dealers. My theory is based on a premise that buy-side investors form a non-binding long-term relationship with core dealers to obtain costly liquidity in bad periods. The main finding is that periphery dealers can help investors with infrequent liquidity needs, those who cannot form the relationship with core dealers directly due to commitment problem, successfully obtain costly liquidity in bad periods. By connecting with several investors and forming relationship with a core dealer on their behalf, periphery dealer will have enough power to pressure the core dealer to commit to the relationship. Therefore, investors with infrequent liquidity needs will trade with periphery dealers to obtain the benefit of long-term relationship, granting market power to periphery dealers to co-exist with core dealers. The third chapter develops a game-theoretic model to study strategic formation of financial network. In the model, a finite number of risk-averse agents who invest in risky projects can issue and trade forward contracts (i.e. assets) to obtain fractions of investment return of other agents. All trades are bilateral, each involving two parties with trading relationship privately bargaining on asset price and quantity. The main objective is to examine how structural properties of trading network determine trading decision of the agents and equilibrium asset allocation. To this end, I use the concept of line graph transformation to identify network of asset flows and map positions of trading links onto the equilibrium outcome. The main insight is that equilibrium asset allocation corresponds to a generalized Bonacich centrality of the network of asset flows.
... The two-trader case is of special interest, mainly because the large majority of risksharing transactions are bilateral between large institutions and/or their clients or brokers; related discussions and statistics are provided in Babus and Hu (2016), Babus (2016Babus ( ), D. et al. (2015, Zawadowski (2013), Hendershott and Madhavan (2015). We obtain explicit expressions for two-trader price-allocation noncompetitive equilibria, which allow us to further analyse the model's economic insight. ...
Thesis
The first part of this thesis deals with the consideration of thin incomplete financial markets, where traders with heterogeneous preferences and risk exposures have motive to behave strategically regarding the demand schedules they submit, thereby impacting prices and allocations. We argue that traders relatively more exposed to market risk tend to submit more elastic demand functions. Noncompetitive equilibrium prices and allocations result as an outcome of a game among traders. General sufficient conditions for existence and uniqueness of such equilibrium are provided, with an extensive analysis of two-trader transactions. Even though strategic behaviour causes inefficient social allocations, traders with sufficiently high risk tolerance and/or large initial exposure to market risk obtain more utility gain in the noncompetitive equilibrium, when compared to the competitive one. The second part of this thesis considers a continuum of potential investors allocating funds in two consecutive periods between a manager and a market index. The manager’s alpha, defined as her ability to generate idiosyncratic returns, is her private information and is either high or low. In each period, the manager receives a private signal on the potential performance of her alpha, and she also obtains some public news on the market’s condition. The investors observe her decision to either follow a market neutral strategy, or an index tracking one. It is shown that the latter always results in a loss of reputation, which is also reflected on the fund’s flows. This loss is smaller in bull markets, when investors expect more managers to use high beta strategies. As a result, a manager’s performance in bull markets is less informative about her ability than in bear markets, because a high beta strategy does not rely on it. We empirically verify that flows of funds that follow high beta strategies are less responsive to the fund’s performance than those that follow market neutral strategies.
... 9 Indeed, the key contribution of our study is to reveal that the static concept of "domain" factor is insufficient; however, a dynamic concept regarding the "synchronization" factor is indispensable for examining RTGS systems. The implications of the dynamic aspect of RTGS systems have also been examined in simulation-based studies, such as Beck and Soramäki (2001) and With regard to the analysis of financial contagion, the implications of the "connectedness" or "connectivity" of networks are extensively examined by Allen and Gale (2000), Freixas et al. (2000), Lagunoff and Schreft (2001), Cifuentes et al. (2005), Nier et al. (2007), Castiglionesi and Navarro (2008), Caballero and Simsek (2009), Allen et al. (2010), Gai and Kapadia (2010), Battiston et al. (2012a), and Zawadowski (2013). Simulation studies for examining the contribution of connectivity and concentration are conducted by Nier et al. (2007) and Battiston et al. (2012b). ...
Article
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This study investigates the amount of liquidity that is necessary to settle a given network of financial obligations. In our analysis, we assume sequential settlement, which is standard in real-world interbank settlement systems, instead of simultaneous settlement, which is typically assumed in relevant research. We develop a graph-theoretic model and apply a flow network technique to investigate how the interconnected feature could affect the required liquidity. Our main contribution is to show that the effect of the interconnected feature is characterized with our original concepts regarding “twist” properties—arc-twisted and vertex-twisted—that are defined on the basis of the concept of “cycles.” Each of the “twist” properties refers to certain inconsistency in the dynamics of settlements. The characterization provides a consistent and fundamental perspective of how a hub or other network structures affect the required liquidity. We further investigate the quantitative implications of the “twist” properties for real-world networks of obligations by examining networks with clustered structures and small-world structures. We show that “twist” properties have non-linear effects on the required liquidity against an increase in the amount of obligations.
... 8 More recent studies emphasize the role of financial networks as amplifiers of shocks and how these can increase the overall fragility of the system, e.g. Acemoglu et al. (2015), Allen et al. (2012), Battiston et al. (2012), Castiglionesi andNavarro (2007), Krause and Giansante (2012), Wagner (2010) and Zawadowski (2013). ...
Article
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The Basel Committee on Banking Supervision has proposed a methodology to identify Systemically Important Financial Institutions based on a series of indicators that should account for the externalities that these institutions place into the system. In this article we argue that the methodology chosen by Basel III maintains the micro-prudential focus of Basel I and II. We show how the PageRank algorithm that operates behind the Google search engine can be modified and applied to identify Systemically Important Financial Institutions. Being a feedback measure of systemic importance, the PageRank algorithm evaluates more than individual exposures. The algorithm is able to capture the risks that individual institutions place into the system, while at the same time, taking into account how the exposures at the system-wide level affect the ranking of individual institutions. In accordance to the Basel III framework, we are able to distinguish between systemic importance due to exposures born on the asset and on the liability side of the balance sheet of banks.
... See Babus and Allen (2009) for a comprehensive review. Recent works include, but are not limited to, Afonso and Shin (2011), Zawadowski (2012, Acemoglu et al. (2012), Herskovic, andEisfeldt et al. (2020). Recent empirical works also cover a wide range of economic networks (see Yılmaz, 2009, 2014;Billio et al., 2012;Kelly et al., 2013;Duarte and Eisenbach, 2013;Greenwood et al., 2015, andGofman, 2017). ...
... Interesting studies of the knock-on effect have been proposed within the equilibrium modeling (especially with dynamic stochastic general equilibrium models) approach, including studies of contagion byGai and Kapadia [2010];Zawadowski [2013];Babus and Hu [2015];Acemoglu, Ozdaglar and Tahbaz-Salehi [2015] and empirical research byMarkose, Giansante and Shaghaghi [2012]. ...
... Allen and Gale (2000), Acemoglu, Ozdagalar, and Tahbaz-Salehi (2015) and Wang (2016)), and banks would choose to be less interconnected than is socially optimal (e.g. Zawadowski (2013)). ...
... The two-trader case is of special interest, mainly because the large majority of risk-sharing transactions are bilateral between large institutions and/or their clients or brokers; see, among others, the related discussions in [BH16,Bab16,DSV15,Zaw13]. We obtain explicit expressions for two-trader Nash price-allocation equilibria, which allow us to analyse further the economic insight of the model. ...
Article
Full-text available
We consider thin financial markets involving a finite number of tradeable securities. Traders with heterogeneous preferences and risk exposures have motive to behave strategically regarding the level of risk aversion they reveal through the transaction, thereby impacting prices and allocations. We argue that traders relatively more exposed to market risk tend to submit more elastic demand functions, revealing higher risk tolerance. Non-competitive equilibrium prices and allocations result as an outcome of a game among traders. General sufficient conditions for existence and uniqueness of such equilibrium are provided, with an extensive analysis of two-trader transactions. Even though strategic behaviour causes inefficient social allocations, traders with sufficiently high risk tolerance and/or large initial exposure to market risk obtain more utility surplus in the non-competitive equilibrium, when compared to the competitive one.
... There are papers in this area that also emphasize the strategic link formation among financial institutions. Acemoglu et al. [2] and Zawadowsky [36], for example, consider banks located on a network shaped as a ring. While the former paper predicts that the equilibrium network can exhibit both under and over connection, the latter provides a rationale for under-insurance. ...
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... The idea that personal security exhibits positive externalities is well known in the economic epidemiology literature (and has been noted in the recent research in this area; see, e.g., Acemoglu et al. (2013), Cerdeiro et al. (2014), Zawadowski (2013). Moreover, in the standard disease setting security choices are strategic substitutes. ...
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We develop a framework to analyse the credit default swap (CDS) market as a network of risk transfers among counterparties. From a theoretical perspective, we introduce the notion of flow-of-risk and provide sufficient conditions for a bow-tie network architecture to endogenously emerge as a result of intermediation. This architecture shows three distinct sets of counterparties: (i) Ultimate Risk Sellers (URS), (ii) Dealers (indirectly connected to each other), (iii) Ultimate Risk Buyers (URB). We show that the probability of widespread distress due to counterparty risk is higher in a bow-tie architecture than in more fragmented network structures. Empirically, we analyse a unique global dataset of bilateral CDS exposures on major sovereign and financial reference entities in 2011–2014. We find the presence of a bow-tie network architecture consistently across both reference entities and time, and that the flow-of-risk originates from a large number of URSs (e.g. hedge funds) and ends up in a few leading URBs, most of which are non-banks (in particular asset managers). Finally, the analysis of the CDS portfolio composition of the URBs shows a high level of concentration: in particular, the top URBs often show large exposures to potentially correlated reference entities.
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In this paper, I investigate the impact of central clearing in credit risk transfer markets on a loan-originating bank's lending behavior. Under the current market regulation, central clearing undermines banks’ lending discipline. The regulatory design of the credit risk transfer market in terms of capital requirements, disclosure standards, risk retention, and access to uncleared credit risk transfer can mitigate this problem. I also show that the lending discipline channel is an essential element of the impact of central clearing on banks’ loan default loss exposure, which is a first-order consideration for systemic risk analysis.
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We develop a framework to analyse the credit default swap (CDS) market as a network of risk transfers among counterparties. From a theoretical perspective, we introduce the notion of flow-of-risk and provide sufficient conditions for a bow-tie network architecture to endogenously emerge as a result of intermediation. This architecture shows three distinct sets of counterparties: i) Ultimate Risk Sellers (URS), ii) Dealers (indirectly connected to each other), iii) Ultimate Risk Buyers (URB). We show that the probability of widespread distress due to counterparty risk is higher in a bow-tie architecture than in more fragmented network structures. Empirically, we analyse a unique global dataset of bilateral CDS exposures on major sovereign and financial reference entities in 2011 − 2014. We find the presence of a bow-tie network architecture consistently across both reference entities and time, and that the flow-of-risk originates from a large number of URSs (e.g. hedge funds) and ends up in a few leading URBs, most of which are non-banks (in particular asset managers). Finally, the analysis of the CDS portfolio composition of the URBs shows a high level of concentration: in particular, the top URBs often show large exposures to potentially correlated reference entities.
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This paper studies how the Greek credit event in March 2012 impacted the credit default swap (CDS) market. We distinguish direct (i.e. to the Greek CDS market) and indirect effects (to other CDS reference entities). We study these two types of effects both from a market wide and investor behaviour perspectives. For this purpose, we apply multi-layer network tools to a novel global dataset on bilateral CDS exposures and in parallel also perform a time series analysis of the CDS spreads. Our main finding is a number of significant changes in the network structure: primarily (and partly mechanical) effects in the Greek CDS market itself but also changes in the markets similar in credit risk profiles. Our results also provide evidence for the bank-sovereign nexus in the EU. Finally, our results shed light on the behaviour of various types of traders and also role of the credit quality of the reference entities.
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The recent financial crisis has prompted much new research on the interconnectedness of the modern financial system and the extent to which it contributes to systemic fragility. Network connections diversify firms' risk exposures, but they also create channels through which shocks can spread by contagion. We review the extensive literature on this issue, with the focus on how network structure interacts with other key variables such as leverage, size, common exposures, and short-term funding. We discuss various metrics that have been proposed for evaluating the susceptibility of the system to contagion and suggest directions for future research. (JEL D85, E44, G01, G21, G22, G23, G28).
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Credit default swaps (CDS) have been growing in importance in the global financial markets. However, their role has been hotly debated, in industry and academia, particularly since the credit crisis of 2007–2009. We review the extant literature on CDS that has accumulated over the past two decades. We divide our survey into seven topics after providing a broad overview in the introduction. The second section traces the historical development of CDS markets and provides an introduction to CDS contract definitions and conventions. The third section discusses the pricing of CDS, from the perspective of no-arbitrage principles, structural, and reduced-form credit risk models. It also summarizes the literature on the determinants of CDS spreads, with a focus on the role of fundamental credit risk factors, liquidity and counterparty risk. The fourth section discusses how the development of the CDS market has affected the characteristics of the bond and equity markets, with an emphasis on market efficiency, price discovery, information flow, and liquidity. Attention is also paid to the CDS-bond basis, the wedge between the pricing of the CDS and its reference bond, and the mispricing between the CDS and the equity market. The fifth section examines the effect of CDS trading on firms' credit and bankruptcy risk, and how it affects corporate financial policy, including bond issuance, capital structure, liquidity management, and corporate governance. The sixth section analyzes how CDS impact the economic incentives of financial intermediaries. The seventh section reviews the growing literature on sovereign CDS and highlights the major differences between the sovereign and corporate CDS markets. In the eight section, we discuss CDS indices, especially the role of synthetic CDS index products backed by residential mortgage-backed securities during the financial crisis. We close with our suggestions for promising future research directions on CDS contracts and markets.
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We review the extensive literature on systemic risk and connect it to the current regulatory debate. While we take stock of the achievements of this rapidly growing field, we identify a gap between two main approaches. The first one studies different sources of systemic risk in isolation, uses confidential data, and inspires targeted but complex regulatory tools. The second approach uses market data to produce global measures which are not directly connected to any particular theory, but could support a more efficient regulation. Bridging this gap will require encompassing theoretical models and improved data disclosure.
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Network models of interbank exposures allow the mapping of the complex web of financial linkages among many institutions and address issues of system stability and contagion risk. Although existing models cover a fair amount of ground in explaining how network structure can lead to default cascades and in quantifying the likelihood and the impact of default cascades through balance-sheet mechanics, the literature has shortcomings in explaining how shocks are potentially amplified through the network of exposures. These amplification mechanisms seem to be very important in financial crises. This review discusses the main conceptual ideas behind network models of contagion, the major findings of this literature, as well as some limitations of existing models.
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This paper analyses the network structure of the credit default swap (CDS) market and its determinants, using a unique dataset of bilateral notional exposures on 642 financial and sovereign reference entities. We find that the CDS network is centred around 14 major dealers, exhibits a "small world" structure and a scale-free degree distribution. A large share of investors are net CDS buyers, implying that total credit risk exposure is fairly concentrated. Consistent with the theoretical literature on the use of CDS, the debt volume outstanding and its structure (maturity and collateralization), the CDS spread volatility and market beta, as well as the type (sovereign/financial) of the underlying bond are statistically significantly related-with expected signs-to structural characteristics of the CDS market.
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This paper explores whether the level of de facto financial integration of banks in a country increases the incidence of systemic banking crises. The paper computes a measure of financial integration based on network statistics of banks participating in the global market of inter-bank syndicated loans. The network statistics used are indegree, outdegree, betweenness, clustering coefficients, authority, and hub centrality. The paper fits a count data model in the cross-section for the period 1980-2007, and finds that the level of financial integration of the average bank in a country is a robust determinant of the incidence of banking crises. While borrowing (weighted indegree) is positively associated with a higher incidence of crises, betweenness is associated with a lower incidence. That is, the more important is the average bank of a country to the global bank network, as captured by betweenness, the smaller the number of crises the country experiences.
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The recent financial crisis has focused the attention of scholars and policymakers on how to improve financial stability through better macro‐prudential regulation and supervision. In this paper, we compare the existing theoretical and empirical literature on contagion through the banking system. It is argued that the structure of the interbank market, the size of banks, the linkages among them, the level of correlation of their investments and the transparency of the regulator are key factors in determining the possibility of contagion. We discuss the different findings and present avenues for future research.
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To mitigate systemic risk, some regulators have advocated the greater use of centralized counterparties (CCPs) to clear Over-The-Counter (OTC) derivatives trades. Regulators should be cognizant that large banks active in the OTC derivatives market do not hold collateral against all the positions in their trading book and the paper proves an estimate of this under-collateralization. Whatever collateral is held by banks is allowed to be rehypothecated (or re-used) to others. Since CCPs would require all positions to have collateral against them, off-loading a significant portion of OTC derivatives transactions to central counterparties (CCPs) would require large increases in posted collateral, possibly requiring large banks to raise more capital. These costs suggest that most large banks will be reluctant to offload their positions to CCPs, and the paper proposes an appropriate capital levy on remaining positions to encourage the transition.
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Demandable-debt finance by banks warrants explanation because it entails costs of bank suspension, liquidation, and idle reserve holdings. An explanation is developed in which demandable debt provides incentive-compatible intermediation where the banker has comparative advantage in allocating investment funds but may act against the interests of uninformed depositors. Demandable debt attracts funds by giving depositors an option to force liquidation. Its usefulness in transacting follows from information-sharing between monitors and nonmonitors. Copyright 1991 by American Economic Association.
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This article develops a model which shows that bank deposit contracts can provide allocations superior to those of exchange markets, offering an explanation of how banks subject to runs can attract deposits. Investors face privately observed risks which lead to a demand for liquidity. Traditional demand deposit contracts which provide liquidity have multiple equilibria, one of which is a bank run. Bank runs in the model cause real economic damage, rather than simply reflecting other problems. Contracts which can prevent runs are studied, and the analysis shows that there are circumstances when government provision of deposit insurance can produce superior contracts. This article is reprinted from the Journal of Political Economy (June 1983, vol. 91, no. 3, pp. 401--19) with the permission of the University of Chicago Press. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. ...
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This paper investigates the determinants of the amount of credit protection bought (or equivalently sold) in the market for credit default swaps (CDS). Combining new data on net notional CDS positions outstanding from the Depository Trust & Clearing Corporation (DTCC) with a number of other data sources, we find the following main results: (1) Firms with more assets and high debt relative to assets have more CDS outstanding. Looking at disaggregated balance sheet data, the effect of debt on CDS is mainly driven by bonds outstanding. (2) Investment grade firms have more CDS outstanding. (3) Disagreement, in the form of analyst forecast dispersion, is associated with more CDS outstanding, suggesting that investors use the CDS markets to 'take views' on default probabilities. (4) Firms that recently lost investment grade status (fallen angels) have more CDS outstanding, suggesting that investors exposed to these firms use the CDS market to hedge. (5) The effect of disagreement and lost investment grade status on CDS outstanding is driven by firms whose bonds are illiquid, suggesting that investors use CDS markets to take views or hedge exposures when trading in the underlying bond is expensive.
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Credit derivatives have received intense scrutiny -- and criticism -- as a major contributor to the ongoing financial crisis. In response, regulators have proposed requiring the formation of a central clearinghouse to share default risk on these contracts. A comparative economic analysis of the costs and benefits of alternative default risk sharing mechanisms casts considerable doubt on the advisability of central clearing of credit derivatives. These products are likely to be subject to severe information asymmetry problems regarding their value, risk, and the creditworthiness of those who trade them, and these information asymmetries are likely to be less severe in bilateral markets than in centrally cleared systems. Moreover, although regulators have argued that clearing would reduce systemic risk, a more complete analysis demonstrates that clearing could actually increase risks to the broader financial system.
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We show whether central clearing of a particular class of derivatives lowers counterparty risk. For plausible cases, adding a central clearing counterparty (CCP) for a class of derivatives such as credit default swaps reduces netting efficiency, leading to an increase in average exposure to counterparty default. Further, clearing different classes of derivatives in separate CCPs always increases counterparty exposures relative to clearing the combined set of derivatives in a single CCP. We provide theory as well as illustrative numerical examples of these results that are calibrated to notional derivatives position data for major banks.
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The opacity of over-the-counter (OTC) markets – in which a large number of financial products including credit derivatives trade – appears to have played a central role in the ongoing financial crisis. We model such OTC markets for risk-sharing in a general equilibrium setup where agents have incentives to default and their financial positions are not mutually observable. We show that in this setting, there is excess "leverage" in that parties in OTC contracts take on short positions that lead to levels of default risk that are higher than Pareto-efficient ones. In particular, OTC markets feature a counterparty risk externality that we show can lead to ex-ante productive inefficiency. This externality is absent when trading is organized via a centralized clearing mechanism that provides transparency of trade positions, or centralized counterparty such as an exchange that observes all trades and sets prices.
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We develop a model of endogenous maturity structure for financial institutions that borrow from multiple creditors. We show that a maturity rat race can occur: an individual creditor can have an incentive to shorten the maturity of his own loan to the institution, allowing him to adjust his financing terms or pull out before other creditors can. This, in turn, causes all other lenders to shorten their maturity as well, leading to excessively short-term financing. This rat race occurs when interim information is mostly about the probability of default rather than the recovery in default, and is most pronounced during volatile periods and crises. Overall, firms are exposed to unnecessary rollover risk.Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.
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Financial contagion is modeled as an equilibrium phenomenon. Because liquidity preference shocks are imperfectly correlated across regions, banks hold interregional claims on other banks to provide insurance against liquidity preference shocks. When there is no aggregate uncertainty, the first-best allocation of risk sharing can be achieved. However, this arrangement is financially fragile. A small liquidity preference shock in one region can spread by contagion throughout the economy. The possibility of contagion depends strongly on the completeness of the structure of interregional claims. Complete claims structures are shown to be more robust than incomplete structures.
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Chapter 11 bars bankrupt debtors from immediately repaying their creditors, so that the bankrupt firm can reorganize without creditors shredding the bankrupt’s business. Not so for the bankrupt’s derivatives counterparties, who unlike most creditors, even most other secured creditors, can seize and immediately liquidate collateral, net out gains and losses, terminate their contracts with the bankrupt, and keep both preferential eve-of-bankruptcy payments and fraudulent conveyances they obtained from the debtor in ways that favor them over other creditors. Their right to jump to the head of the bankruptcy re-payment line, in ways that even ordinary secured creditors cannot, weakens their incen-tives for market discipline in managing their credits to the debtor; it reduces their concern for the risk of counterparty failure and bankruptcy, since they do well in any resulting bankruptcy. If they were made to account better for counterparty risk, they would be more likely to insist that there be stronger counterparties than otherwise on the other side of their derivatives bets, thereby insisting for their own good on strengthening the financial system. True, because they bear less risk, nonprioritized creditors bear more and thus have more incentive to monitor the debtor or to assure themselves that the debtor is a safe bet. But the repo and derivatives market’s other creditors - such as the United States of America - are poorly positioned contractually either to consistently monitor the deriva-tives debtors’ well or to fully replicate the needed market discipline. Bankruptcy policy should harness private incentives for counterparty market discipline by cutting back the extensive de facto priorities for these investment channels now embedded in chapter 11 and related laws. More generally, when we subsidize derivatives and repos activity via bankruptcy benefits not open to other creditors, we get more of the activity than we oth-erwise would. Repeal would induce the derivatives market to better recognize the risks of counterparty financial failure, which in turn should dampen the possibility of another AIG/Bear/Lehman financial meltdown, thereby helping to maintain financial stability. Re-peal would lift the de facto bankruptcy subsidy. Yet the major financial reform package Congress just enacted lacked the needed cutbacks.
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The collapse of Long Term Capital Management (LTCM) in Fall 1998 and the Federal Reserve Bank's subsequent efforts to orchestrate a bailout raise important questions about the structure of the Bankruptcy Code. The Code contains numerous provisions affording special treatment to financial derivatives contracts, the most important of which exempts these contracts from the "automatic stay" and permits counterparties to terminate derivatives contracts with a debtor in bankruptcy and seize underlying collateral. No other counterparty or creditor of the debtor has such freedom; to the contrary, the automatic stay prohibits them from undertaking any act that threatens the debtor's assets. It is commonly believed that the exemption for derivatives contracts helps reduce "systemic risk" in financial markets, that is, the risk that multiple major financial market participants will fail at the same time and, as a result, drastically reduce market liquidity. Indeed, Congress is now contemplating reforms that would extend the exemption to include a broader array of financial contracts, all in the name of reducing systemic risk. This is a mistake. The Bankruptcy Code can do little to reduce systemic risk and may in fact exacerbate it, as the experience of LTCM suggests. Risk of a systemic meltdown arose there and prompted intervention by the Fed precisely because derivatives contracts were exempt from the automatic stay. Derivatives contracts may merit special treatment, but fear of systemic risk is a red herring. A better, efficiency-based reason for treating derivatives contracts differently arises naturally from the economic theory underlying the automatic stay. The stay protects assets to the extent they are needed to preserve a firm's going-concern surplus (its value above and beyond the sale value of its assets). Assets are needed to preserve going-concern surplus only if they are firm-specific, that is, only if they are worth more inside the firm than outside it. This is often true for plant and equipment. It is never true for derivatives contracts. This observation helps rationalize the Code's treatment of derivatives contracts and other features of the automatic stay. There are, however, downsides to treating derivatives contracts differently (creditors, for example, would like to disguise loans as derivatives contracts). These downsides are probably not significant, but they highlight the fragility of the Code's treatment of derivatives contracts, which should worry members of Congress as they consider arguments to expand the Code's exemptions for derivatives contracts.
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Many observers have argued that credit default swaps contributed significantly to the credit crisis. Of particular concern to these observers are that credit default swaps trade in the largely unregulated over-the-counter market as bilateral contracts involving counterparty risk and that they facilitate speculation involving negative views of a firm's financial strength. Some observers have suggested that credit default swaps would not have made the crisis worse had they traded on exchanges. I conclude that credit default swaps did not cause the dramatic events of the credit crisis, that the over-the-counter credit default swaps market worked well during much of the crisis, and that exchange trading has both advantages and costs compared to over-the-counter trading. Though I argue that eliminating over-the-counter trading of credit default swaps could reduce social welfare, I also recognize that much research is needed to understand better and to quantify the social gains and costs of derivatives in general and credit default swaps in particular.
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We study interbank lending and asset sales markets in which banks with surplus liquidity have market power vis-a-vis banks needing liquidity, frictions arise in lending due to moral hazard, and assets are bank-specific. Surplus banks ration lending and instead purchase assets from needy banks, an inefficiency more acute during financial crises. A central bank acting as a lender-of-last-resort can ameliorate this inefficiency provided it is prepared to extend potentially loss-making loans or is better informed than outside markets, as might be the case if it also performs a supervisory role. This rationale for central banking finds support in historical episodes. (JEL E58, G01, G21, G28, L13, N21)
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In the U.S., as in most countries with well-developed securities markets, derivative securities enjoy special protections under insolvency resolution laws. Most creditors are “stayed” from enforcing their rights while a firm is in bankruptcy. However, many derivatives contracts are exempt from these stays. Furthermore, derivatives enjoy netting and closeout, or termination, privileges which are not always available to most other creditors. The primary argument used to motivate passage of legislation granting these extraordinary protections is that derivatives markets are a major source of systemic risk in financial markets and that netting and closeout reduce this risk. To date, these assertions have not been subjected to rigorous economic scrutiny. This paper critically re-examines this hypothesis. These relationships are more complex than often perceived. We conclude that it is not clear whether netting, collateral, and/or closeout lead to reduced systemic risk, once the impact of these protections on the size and structure of the derivatives market has been taken into account.
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Loans are illiquid when a lender needs relationship-specific skills to collect them. Consequently, if the relationship lender needs funds before the loan matures, she may demand to liquidate early, or require a return premium, when she lends directly. Borrowers also risk losing funding. The costs of illiquidity are avoided if the relationship lender is a bank with a fragile capital structure, subject to runs. Fragility commits banks to creating liquidity, enabling depositors to withdraw when needed, while buffering borrowers from depositors' liquidity needs. Stabilization policies, such as capital requirements, narrow banking, and suspension of convertibility, may reduce liquidity creation.
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I. Introduction, 488. — II. The model with automobiles as an example, 489. — III. Examples and applications, 492. — IV. Counteracting institutions, 499. — V. Conclusion, 500.
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The authors study an incentive model of financial intermediation in which firms as well as intermediaries are capital constrained. They analyze how the distribution of wealth across firms, intermediaries, and uninformed investors affects investment, interest rates, and the intensity of monitoring. The authors show that all forms of capital tightening (a credit crunch, a collateral squeeze, or a savings squeeze) hit poorly capitalized firms the hardest, but that interest rate effects and the intensity of monitoring will depend on relative changes in the various components of capital. The predictions of the model are broadly consistent with the lending patterns observed during the recent financial crises. Copyright 1997, the President and Fellows of Harvard College and the Massachusetts Institute of Technology.
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Financial contagion is modeled as an equilibrium phenomenon in a dynamic setting with incomplete information and multiple banks. The equilibrium probability of bank failure is uniquely determined. We explore how the cross-holding of deposits motivated by imperfectly correlated regional liquidity shocks can lead to contagious effects conditional on the failure of a financial institution. We show that contagious bank failure occurs with positive probability in the unique equilibrium of the economy and demonstrate that the presence of such contagion risk can prevent banks from perfectly insuring each other against liquidity shocks via the cross-holding of deposits. (JEL: G2, C7) Copyright (c) 2004 by the European Economic Association.
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We study equilibria for economies with hidden action in environments in which the agents' contractual relationships with competing financial intermediaries cannot be monitored (or are not contractible upon). We fully characterize equilibrium allocations and contracts for such economies, as well as discuss their welfare properties. Depending on the parameters of the economy, either the optimal action choice is not sustained in equilibrium or, if it is, agents necessarily enter into multiple contractual relationships and intermediaries make positive profits, even under free-entry conditions. The main features and implications of these environments are consistent with several stylized facts of markets for unsecured loans.
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The random graph of Erdos and Renyi is one of the oldest and best studied models of a network, and possesses the considerable advantage of being exactly solvable for many of its average properties. However, as a model of real-world networks such as the Internet, social networks or biological networks it leaves a lot to be desired. In particular, it differs from real networks in two crucial ways: it lacks network clustering or transitivity, and it has an unrealistic Poissonian degree distribution. In this paper we review some recent work on generalizations of the random graph aimed at correcting these shortcomings. We describe generalized random graph models of both directed and undirected networks that incorporate arbitrary non-Poisson degree distributions, and extensions of these models that incorporate clustering too. We also describe two recent applications of random graph models to the problems of network robustness and of epidemics spreading on contact networks.
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Incentive compensation induces correlation between the portfolio of managers and the cash flow of the firms they manage. This correlation exposes managers to risk and hence gives them an incentive to hedge against the poor performance of their firms. We study the agency problem between shareholders and a manager when the manager can hedge his compensation using financial markets and shareholders can monitor the manager’s portfolio in order to keep him from hedging, but monitoring is costly. We find that the optimal incentive compensation and governance provisions have the following properties: (i) the manager’s portfolio is monitored only when the firm performs poorly, (ii) the manager’s compensation is more sensitive to firm performance when the cost of monitoring is higher or when hedging markets are more developed, and (iii) conditional on the firm’s performance, the manager’s compensation is lower when his portfolio is monitored, even if no hedging is revealed by monitoring. Moreover, the model suggests that the optimal level of portfolio monitoring is higher for managers of firms whose performance can be hedged more easily, such as larger firms and firms in more developed financial markets.
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This paper examines the degree to which the failure of one bank would cause the subsequent collapse of other banks. Using unique data on interbank payment flows, the magnitude of bilateral federal funds exposures is quantified. These exposures are used to simulate the impact of various failure scenarios, and the risk of contagion is found to be economically small.
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This paper examines the likelihood that failure of one bank would cause the subsequent collapse of a large number of other banks. Using unique data on interbank payment flows, the magnitude of bilateral federal funds exposures is quantified. These exposures are used to simulate the impact of various failure scenarios, and the risk of contagion is found to be economically small.
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This paper develops a general framework for analyzing corporate risk management policies. We begin by observing that if external sources of finance are more costly to corporations than internally generated funds, there will typically be a benefit to hedging: hedging adds value to the extent that it helps ensure that a corporation has sufficient internal funds available to take advantage of attractive investment opportunities. We then argue that this simple observation has wide ranging implications for the design of risk management strategies. We delineate how these strategies should depend on such factors as shocks to investment and financing opportunities. We also discuss exchange rate hedging strategies for multinationals, as well as strategies involving 'nonlinear'instruments like options. Copyright 1993 by American Finance Association.
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We study the stability and efficiency of social and economic networks, when self-interested individuals have the discretion to form or sever links. First, in the context of two stylized models, we characterize the sets of stable networkds (immune to incentives to form or sever links) and the sets of efficient networks (those which maximize total production or utility). The sets of stable networks and efficients networks do not always intersect. Next, we show that this tension is not unique to these models, but persists generally. In order to assure that there is always at least one efficient graph which is stable, one is forced to allocate resources to nodes (players) who are not responsible for any of the production. We characterize one such allocations rule: the equal split rule. We characterize another rule which fails to assure that efficient graphs are stable, but arises naturally if the allocations result from the bargaining of players.
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Modern banking systems are highly interconnected. Despite their various benefits, the linkages that exist between banks carry the risk of contagion. In this paper we investigate how banks decide on direct balance sheet linkages and the implications for contagion risk. In particular, we model a network formation process in the banking system. The trade-off between the gains and the risks of being connected shapes banks ’incentives to form links. We show that banks manage to form networks that are resilient to contagion. Thus, in an equilibrium network, the probability of contagion is virtually 0.
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Matching university places to students is not as clear cut or as straightforward as it ought to be. By investigating the matching algorithm used by the German central clearinghouse for university admissions in medicine and related subjects, we show that a procedure designed to give an advantage to students with excellent school grades actually harms them. The reason is that the three-step process employed by the clearinghouse is a complicated mechanism in which many students fail to grasp the strategic aspects involved. The mechanism is based on quotas and consists of three procedures that are administered sequentially, one for each quota. Using the complete data set of the central clearinghouse, we show that the matching can be improved for around 20% of the excellent students while making a relatively small percentage of all other students worse off.
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Textbook arbitrage in financial markets requires no capital and entails no risk. In reality, almost all arbitrage requires capital and is typically risky. Moreover, professional arbitrage is conducted by a relatively small number of highly specialized investors using other people's capital. Such professional arbitrage has a number of interesting implications for security pricing, including the possibility that arbitrage becomes ineffective in extreme circumstances when prices diverge far from fundamental values. The model also suggests where anomalies in financial markets are likely to appear, and why arbitrage fails to eliminate them. Copyright 1997 by American Finance Association.
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Trading losses associated with information asymmetries can be mitigated by designing securities that split the cash flows of underlying assets. These securities, which can arise endogenously, have values that do not depend on the information known only to informed agents. Bank debt (deposits) is an example of this type of liquid security that protects relatively uninformed agents, and the authors provide a rationale for deposit insurance in this content. High-grade corporate debt and government bonds are other examples, implying that a money market mutual fund based payments system may be an alternative to one based on insured bank deposits. Copyright 1990 by American Finance Association.
Article
We study a financial network characterized by the presence of depositors, banks and their shareholders. Belonging to a financial network is beneficial for both the depositors and banks' shareholders since the return to investment increases with the number of banks connected. However, the network is fragile since banks, which invest on behalf of the depositors, can gamble with depositors' money (making an investment that is dominated in expected terms) when not sufficiently capitalized. The bankruptcy of a bank negatively affects the banks connected to it in the network. First, we compute the social planner solution and the efficient financial network is characterized by a core-periphery structure. Second, we analyze the decentralized solution showing under which conditions participating in a fragile financial network is ex-ante optimal. In particular, we show that this is optimal when the probability of bankruptcy is sufficiently low giving rationale of financial fragility as a rare phenomenon. Finally, we analyze the efficiency of the decentralized financial network. Again, if the probability of bankruptcy is sufficiently low the structure of the decentralized financial network is equal to the e? cient one, yielding an ex- pected payo? arbitrarily close to the efficient one. However, the investment decision is not the same. That is, in the decentralized network some banks will gamble as compared to the socially preferred outcome.
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By committing to terminate funding if a firm's performance is poor, investors can mitigate managerial incentive problems. These optimal financial constraints, however, encourage rivals to ensure that a firm's performance is poor; this raises the chance that the financial constraints become binding and induce exit. The authors analyze the optimal financial contract in light of this predatory threat. The optimal contract balances the benefits of deterring predation by relaxing financial constraints against the cost of exacerbating incentive problems. Copyright 1990 by American Economic Association.
  • Ricardo J Caballero
  • Alp Simsek
Caballero, Ricardo J. and Alp Simsek, " Complexity and Financial Panics, " NBER Working Paper, No. 14997, 2009.