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Entangled Financial Systems

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  • Adam Zawadowski

Abstract

I model an entangled financial system in which banks hedge their portfolio risks using over-the-counter (OTC) contracts. However, banks choose not to hedge counterparty risk, and thus the idiosyncratic failure of a bank can lead to a systemic run of lenders. An inefficiency arises because banks engage in a version of risk shifting through the network externalities created by OTC contracts. Banks do not take into account that the costly hedging of low-probability counterparty risk also benefits other banks. In the model, it is welfare improving to tax OTC contracts to finance a bailout fund. The Author 2013. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: journals.permissions@oup.com., Oxford University Press.

Suggested Citation

  • Adam Zawadowski, 2013. "Entangled Financial Systems," Review of Financial Studies, Society for Financial Studies, vol. 26(5), pages 1291-1323.
  • Handle: RePEc:oup:rfinst:v:26:y:2013:i:5:p:1291-1323
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