Intermediation and Voluntary Exposure to Counterparty Risk

Abstract

I study a model of the financial sector in which intermediation among debt-financed banks gives rise to an endogenous core-periphery network. 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 that make risky investments “overconnect,” exposing themselves to excessive counterparty risk, while banks that mainly provide funding end up with too few connections.