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Correlated Default and Financial Intermediation

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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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  • Gregory Phelan, 2015. "Correlated Default and Financial Intermediation," Department of Economics Working Papers 2015-01, Department of Economics, Williams College, revised Sep 2016.
    • Handle: RePEc:wil:wileco:2015-01
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    1. Acharya, Viral V., 2009. "A theory of systemic risk and design of prudential bank regulation," Journal of Financial Stability, Elsevier, vol. 5(3), pages 224-255, September.
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    4. Acharya, Viral V. & Bharath, Sreedhar T. & Srinivasan, Anand, 2007. "Does industry-wide distress affect defaulted firms? Evidence from creditor recoveries," Journal of Financial Economics, Elsevier, vol. 85(3), pages 787-821, September.
    5. Chen, Bo, 2012. "All-or-nothing payments," Journal of Mathematical Economics, Elsevier, vol. 48(3), pages 133-142.
    6. Townsend, Robert M., 1979. "Optimal contracts and competitive markets with costly state verification," Journal of Economic Theory, Elsevier, vol. 21(2), pages 265-293, October.
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    Cited by:

    1. Javadi, Siamak & Mollagholamali, Mohsen, 2018. "Debt market illiquidity and correlated default risk," Finance Research Letters, Elsevier, vol. 26(C), pages 266-273.
    2. 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.
    3. André F. Silva, 2019. "Strategic Liquidity Mismatch and Financial Sector Stability," Finance and Economics Discussion Series 2019-082, Board of Governors of the Federal Reserve System (U.S.).
    4. Anna Maria C. Menichini & Peter J. Simmons, 2017. "Efficient audits by pooling projects," Discussion Papers 17/19, Department of Economics, University of York.
    5. 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).
    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. Yildirim, Alev, 2020. "The effect of relationship banking on firm efficiency and default risk," Journal of Corporate Finance, Elsevier, vol. 65(C).
    8. Peter J. Simmons & Nongnuch Tantisantiwong, 2022. "The Socially Optimal Loan Auditing with Multiple Projects," Discussion Papers 22/07, Department of Economics, University of York.
    9. Antic, Nemanja & Hu, Tai-Wei, 2024. "Optimal banking with delegated monitoring," Journal of Economic Theory, Elsevier, vol. 222(C).

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    Keywords

    Financial intermediation; systemic risk; default;
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