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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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Suggested Citation

  • Allen, Franklin & Carletti, Elena, 2006. "Credit risk transfer and contagion," Journal of Monetary Economics, Elsevier, vol. 53(1), pages 89-111, January.
  • Handle: RePEc:eee:moneco:v:53:y:2006:i:1:p:89-111
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    References listed on IDEAS

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    1. repec:ucp:bknber:9780226454627 is not listed on IDEAS
    2. 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.
    3. Wagner, Wolf & Marsh, Ian W., 2006. "Credit risk transfer and financial sector stability," Journal of Financial Stability, Elsevier, pages 173-193.
    4. Franklin Allen & Douglas Gale, 2004. "Financial Intermediaries and Markets," Econometrica, Econometric Society, vol. 72(4), pages 1023-1061, July.
    5. Cantillo, Miguel & Wright, Julian, 2000. "How Do Firms Choose Their Lenders? An Empirical Investigation," Review of Financial Studies, Society for Financial Studies, pages 155-189.
    6. 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.
    7. Franklin Allen & Douglas Gale, 1990. "Incomplete Markets and Incentives to Set Up an Options Exchange*," The Geneva Risk and Insurance Review, Palgrave Macmillan;International Association for the Study of Insurance Economics (The Geneva Association), vol. 15(1), pages 17-46, March.
    8. Duffee, Gregory R. & Zhou, Chunsheng, 2001. "Credit derivatives in banking: Useful tools for managing risk?," Journal of Monetary Economics, Elsevier, pages 25-54.
    9. David M. G. Newbery & Joseph E. Stiglitz, 1984. "Pareto Inferior Trade," Review of Economic Studies, Oxford University Press, vol. 51(1), pages 1-12.
    10. Alan Morrison, 2000. "Credit Derivatives, Disintermediation and Investment Decisions," OFRC Working Papers Series 2001fe01, Oxford Financial Research Centre.
    11. Antonio Nicolo' & Loriana Pelizzon, 2005. "Credit Derivatives: Capital Requirements and Strategic Contracting," "Marco Fanno" Working Papers 0006, Dipartimento di Scienze Economiche "Marco Fanno".
    12. Guillaume Plantin, 2006. "Does Reinsurance Need Reinsurers?," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 73(1), pages 153-168.
    13. Wagner, Wolf, 2007. "The liquidity of bank assets and banking stability," Journal of Banking & Finance, Elsevier, vol. 31(1), pages 121-139, January.
    14. 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.
    15. Duffee, Gregory R. & Zhou, Chunsheng, 2001. "Credit derivatives in banking: Useful tools for managing risk?," Journal of Monetary Economics, Elsevier, pages 25-54.
    16. David Cass & Alessandro Citanna, 1998. "Pareto improving financial innovation in incomplete markets," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), pages 467-494.
    17. Franklin Allen & Douglas Gale, 1998. "Optimal Financial Crises," Journal of Finance, American Finance Association, vol. 53(4), pages 1245-1284, August.
    18. Allen, Franklin & Gale, Douglas, 2000. "Optimal currency crises," Carnegie-Rochester Conference Series on Public Policy, Elsevier, pages 177-230.
    19. Franklin Allen & Douglas Gale, 2000. "Optimal Currency Crises," Center for Financial Institutions Working Papers 00-23, Wharton School Center for Financial Institutions, University of Pennsylvania.
    20. David Cass & Alessandro Citanna, 1998. "Pareto improving financial innovation in incomplete markets," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), pages 467-494.
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    More about this item

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies

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