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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. Chen, Bo, 2012. "All-or-nothing payments," Journal of Mathematical Economics, Elsevier, vol. 48(3), pages 133-142.
    5. Rui R. Zhao, 2008. "All-or-Nothing Monitoring," American Economic Review, American Economic Association, vol. 98(4), pages 1619-1628, September.
    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, 2019. "Mortgage Finance and Climate Change: Securitization Dynamics in the Aftermath of Natural Disasters," NBER Working Papers 26322, National Bureau of Economic Research, Inc.
    3. Andre 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. Yildirim, Alev, 2020. "The effect of relationship banking on firm efficiency and default risk," Journal of Corporate Finance, Elsevier, vol. 65(C).

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    Keywords

    Financial intermediation; systemic risk; default;
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