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Credit risk transfer and contagion

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  • Allen, Franklin
  • Carletti, Elena

Abstract

Some have argued that recent increases in credit risk transfer are desirable because they improve the diversification of risk. Others have suggested that they may be undesirable if they increase the risk of financial crises. Using a model with banking and insurance sectors, we show that credit risk transfer can be beneficial when banks face uniform demand for liquidity. However, when they face idiosyncratic liquidity risk and hedge this risk in an interbank market, credit risk transfer can be detrimental to welfare. It can lead to contagion between the two sectors and increase the risk of crises. --

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Monetary Economics.

Volume (Year): 53 (2006)
Issue (Month): 1 (January)
Pages: 89-111

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Handle: RePEc:eee:moneco:v:53:y:2006:i:1:p:89-111

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Web page: http://www.elsevier.com/locate/inca/505566

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References

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  1. Duffee, Gregory R. & Zhou, Chunseng, 1999. "Credit Derivatives in Banking: Useful Tools for Managing Risk?," Research Program in Finance, Working Paper Series qt7g67n911, Research Program in Finance, Institute for Business and Economic Research, UC Berkeley.
  2. Wagner, Wolf, 2007. "The liquidity of bank assets and banking stability," Journal of Banking & Finance, Elsevier, vol. 31(1), pages 121-139, January.
  3. Franklin Allen & Douglas Gale, 2004. "Financial Intermediaries and Markets," Econometrica, Econometric Society, vol. 72(4), pages 1023-1061, 07.
  4. Alan Morrison, 2000. "Credit Derivatives, Disintermediation and Investment Decisions," OFRC Working Papers Series 2001fe01, Oxford Financial Research Centre.
  5. repec:ucp:bknber:9780226454627 is not listed on IDEAS
  6. Franklin Allen & Douglas Gale, 1976. "Optimal Financial Crises," Center for Financial Institutions Working Papers 97-01, Wharton School Center for Financial Institutions, University of Pennsylvania.
  7. Newbery, David M G & Stiglitz, Joseph E, 1984. "Pareto Inferior Trade," Review of Economic Studies, Wiley Blackwell, vol. 51(1), pages 1-12, January.
  8. Guillaume Plantin & Christine A Parlour, . "Credit Risk Transfer," GSIA Working Papers 2005-E45, Carnegie Mellon University, Tepper School of Business.
  9. David Cass & Alessandro Citanna, 1998. "Pareto improving financial innovation in incomplete markets," Economic Theory, Springer, vol. 11(3), pages 467-494.
  10. Franklin Allen & Douglas Gale, 2005. "From Cash-in-the-Market Pricing to Financial Fragility," Journal of the European Economic Association, MIT Press, vol. 3(2-3), pages 535-546, 04/05.
  11. Allen, Franklin & Gale, Douglas, 2000. "Optimal currency crises," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 53(1), pages 177-230, December.
  12. Wagner, Wolf & Marsh, Ian W., 2006. "Credit risk transfer and financial sector stability," Journal of Financial Stability, Elsevier, vol. 2(2), pages 173-193, June.
  13. Antonio Nicolo' & Loriana Pelizzon, 2005. "Credit Derivatives: Capital Requirements and Strategic Contracting," "Marco Fanno" Working Papers 0006, Dipartimento di Scienze Economiche "Marco Fanno".
  14. Franklin Allen & Douglas Gale, 1990. "Incomplete Markets and Incentives to Set Up an Options Exchange*," The Geneva Risk and Insurance Review, Palgrave Macmillan, vol. 15(1), pages 17-46, March.
  15. Hart, Oliver D., 1975. "On the optimality of equilibrium when the market structure is incomplete," Journal of Economic Theory, Elsevier, vol. 11(3), pages 418-443, December.
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