Intermediation and Voluntary Exposure to Counterparty Risk

TL;DRAbstract

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.

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