Counterparty Choice, Bank Interconnectedness, and Systemic Risk

Andrew Ellul and Dasol Kim

No 16458, CEPR Discussion Papers from Centre for Economic Policy Research

Abstract: We provide evidence on how banks form network connections and endogenous risk-taking in their non-bank counterparty choices in the OTC derivative markets. We use confidential regulatory data from the Capital Assessment and Stress Testing reports that provide counterparty-level data across a wide range of OTC markets for the most systemically important U.S. banks. We show that banks are more likely to either establish or maintain a relationship, and increase their exposures within an existing relationship, with non-bank counterparties that are already heavily connected and exposed to other banks. Banks in such densely-connected networks are more likely to connect with riskier counterparties for their most material exposures. The effects are strongest in the case of (non-bank) financial counterparties. These findings suggest moral hazard behavior in counterparty choices. Finally, we demonstrate that these exposures are strongly linked to systemic risk. Overall, the results suggest a network formation process that amplifies risk propagation through non-bank linkages in opaque financial markets.

Keywords: Counterparty risk; Financial networks; Bank interconnectedness; Over-the-counter markets; Derivatives (search for similar items in EconPapers)
JEL-codes: D82 G21 G22 (search for similar items in EconPapers)
Date: 2021-08
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