Correlated Default and Financial Intermediation

Gregory Phelan

No 2015-01, Department of Economics Working Papers from Department of Economics, Williams College

Abstract: 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.

Keywords: Financial intermediation; systemic risk; default (search for similar items in EconPapers)
Pages: 41 pages
Date: 2015-04, Revised 2016-09
New Economics Papers: this item is included in nep-ban, nep-dge, nep-ppm and nep-rmg
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Published in The Journal of Finance, June 2017, 72(3): 1253-1284.

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Journal Article: Correlated Default and Financial Intermediation (2017)
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