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Correlated Default and Financial Intermediation

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  • GREGORY PHELAN

Abstract

Financial intermediation naturally arises when knowledge about the aggregate state is valuable for managing investments and lenders cannot easily observe the aggregate state. I show this using a costly enforcement model in which lenders need ex-post incentives to enforce payments from defaulted loans and borrowers' payoffs are correlated. When projects have correlated outcomes, learning the state of one project (via enforcement) provides information about the states of other projects. A large, correlated portfolio provides ex-post incentives for enforcement; as a result, intermediation dominates direct lending, intermediaries are financed with risk-free deposits, earn positive profits, and hold systemic default risk.
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Suggested Citation

  • Gregory Phelan, 2017. "Correlated Default and Financial Intermediation," Journal of Finance, American Finance Association, vol. 72(3), pages 1253-1284, June.
    • Handle: RePEc:bla:jfinan:v:72:y:2017:i:3:p:1253-1284
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    File URL: http://hdl.handle.net/10.1111/jofi.2017.72.issue-3
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    Cited by:

    1. Benhabib, Jess & Dong, Feng & Wang, Pengfei & Xu, Zhenyang, 2025. "Aggregate demand externality and self-fulfilling default cycles," Journal of Monetary Economics, Elsevier, vol. 156(C).
    2. Javadi, Siamak & Mollagholamali, Mohsen, 2018. "Debt market illiquidity and correlated default risk," Finance Research Letters, Elsevier, vol. 26(C), pages 266-273.
    3. Amine Ouazad & Matthew E Kahn, 2022. "Mortgage Finance and Climate Change: Securitization Dynamics in the Aftermath of Natural Disasters," The Review of Financial Studies, Society for Financial Studies, vol. 35(8), pages 3617-3665.
    4. Kim, Dohan, 2025. "The Asymmetric Bank Distress Amplifier of Recessions," Policy Research Working Paper Series 11170, The World Bank.
    5. André F Silva, 2019. "Strategic Liquidity Mismatch and Financial Sector Stability," The Review of Financial Studies, Society for Financial Studies, vol. 32(12), pages 4696-4733.
    6. Pedro Manuel Nogueira Reis & António Pedro Soares Pinto, 2022. "How Do Banking Characteristics Influence Companies’ Debt Features and Performance during COVID-19? A Study of Portuguese Firms," IJFS, MDPI, vol. 10(4), pages 1-29, October.
    7. Anna Maria C. Menichini & Peter J. Simmons, 2017. "Efficient audits by pooling projects," Discussion Papers 17/19, Department of Economics, University of York.
    8. Yildirim, Alev, 2020. "The effect of relationship banking on firm efficiency and default risk," Journal of Corporate Finance, Elsevier, vol. 65(C).
    9. Kosenko, Konstantin & Michelson, Noam, 2022. "It takes more than two to tango: Multiple bank lending, asset commonality and risk," Journal of Financial Stability, Elsevier, vol. 61(C).
    10. Peter J. Simmons & Nongnuch Tantisantiwong, 2022. "The Socially Optimal Loan Auditing with Multiple Projects," Discussion Papers 22/07, Department of Economics, University of York.
    11. Antic, Nemanja & Hu, Tai-Wei, 2024. "Optimal banking with delegated monitoring," Journal of Economic Theory, Elsevier, vol. 222(C).

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