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Collective Moral Hazard and the Interbank Market
The concentration of risk within financial system is considered to be a source of systemic instability. We propose a theory to explain the structure of the financial system and show how it alters the risk taking incentives of financial institutions. We build a model of portfolio choice and endogenous contracts in which the government optimally intervenes during crises. By issuing financial claims to other institutions, relatively risky institutions endogenously become large and interconnected. This structure enables institutions to share the risk of systemic crisis in a privately optimal way, ...
Collateralized Debt Networks with Lender Default
The Lehman Brothers' 2008 bankruptcy spread losses to its counterparties even when Lehman was a lender of cash, because collateral for that lending was tied up in the bankruptcy process. I study the implications of such lender default using a general equilibrium network model featuring endogenous leverage, endogenous asset prices, and endogenous network formation. The multiplex graph model has two channels of contagion: a counterparty channel of contagion and a price channel of contagion through endogenous collateral price. Borrowers diversify their lenders because of the counterparty risk, ...