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Credit risk transfer and contagion

  • Allen, Franklin
  • Carletti, Elena

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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File URL: http://econstor.eu/bitstream/10419/25423/1/504023675.PDF
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Paper provided by Center for Financial Studies (CFS) in its series CFS Working Paper Series with number 2005/25.

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Date of creation: 2005
Date of revision:
Handle: RePEc:zbw:cfswop:200525
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  1. Newbery, David M G & Stiglitz, Joseph E, 1984. "Pareto Inferior Trade," Review of Economic Studies, Wiley Blackwell, vol. 51(1), pages 1-12, January.
  2. Gregory R. Duffee & Chunsheng Zhou, 1997. "Credit derivatives in banking: useful tools for managing risk?," Finance and Economics Discussion Series 1997-13, Board of Governors of the Federal Reserve System (U.S.).
  3. Antonio Nicolo' & Loriana Pelizzon, 2005. "Credit Derivatives: Capital Requirements and Strategic Contracting," "Marco Fanno" Working Papers 0006, Dipartimento di Scienze Economiche "Marco Fanno".
  4. Guillaume Plantin & Christine A Parlour, . "Credit Risk Transfer," GSIA Working Papers 2005-E45, Carnegie Mellon University, Tepper School of Business.
  5. David Cass & Alessandro Citanna, 1998. "Pareto improving financial innovation in incomplete markets," Economic Theory, Springer, vol. 11(3), pages 467-494.
  6. Franklin Allen & Douglas Gale, 2004. "Financial Intermediaries and Markets," Econometrica, Econometric Society, vol. 72(4), pages 1023-1061, 07.
  7. 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.
  8. repec:ucp:bknber:9780226454627 is not listed on IDEAS
  9. 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.
  10. 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.
  11. Alan Morrison, 2000. "Credit Derivatives, Disintermediation and Investment Decisions," OFRC Working Papers Series 2001fe01, Oxford Financial Research Centre.
  12. Franklin Allen & Douglas Gale, 1990. "Incomplete Markets and Incentives to Set Up an Options Exchange*," The Geneva Risk and Insurance Review, Palgrave Macmillan, vol. 15(1), pages 17-46, March.
  13. 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.
  14. Wagner, Wolf, 2007. "The liquidity of bank assets and banking stability," Journal of Banking & Finance, Elsevier, vol. 31(1), pages 121-139, January.
  15. Wagner, Wolf & Marsh, Ian W., 2006. "Credit risk transfer and financial sector stability," Journal of Financial Stability, Elsevier, vol. 2(2), pages 173-193, June.
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