Research

This paper provides a theory of endogenous intermediation in over-the-counter markets. Intermediation arises to allow agents that meet infrequently to trade risky assets without collateral. Since the chance of meeting the same counterparty in the future is very small, an agent chooses to develop a long-term relationship with another trader who then acts as an intermediary. A relationship between two traders enables them to condition current and future terms of trade on information they have about past transactions. Two forces drive agents' decisions to form relationships. First, gathering information about counterparties is costly. Second, if agents intermediate transactions between others, they require to be compensated for it. A trade-off between forming many relationships and trading through intermediaries arises. Although agents are ex-ante symmetric, in equilibrium a central broker-dealer intermediates all the trade in the market. In addition, I show that the benefit of trading through relationships decreases with the relative difference between the expected return of the assets and the opportunity cost of collateral, and increases in liquid markets.

We develop a model in which asset commonality and short-term debt of banks interact to generate excessive systemic risk. Banks swap assets to diversify their individual risk. Two asset structures arise. In a clustered structure, groups of banks hold common asset portfolios and default together. In an unclustered structure, defaults are more dispersed. Portfolio quality of individual banks is opaque but can be inferred by creditors from aggregate signals about bank solvency. When bank debt is short-term, creditors do not roll over in response to adverse signals and all banks are inefficiently liquidated. This information contagion is more likely under clustered asset structures. In contrast, when bank debt is long-term, welfare is the same under both asset structures.

Modern banking systems are highly interconnected. Despite their various benefits, linkages between banks carry the risk of contagion. In this paper we investigate whether banks can commit ex-ante to mutually insure each other, when there is contagion risk in the financial system. Banks can share the risk through bilateral agreements, and we model their decisions as a network formation game. A financial network that allows losses to be shared among various counterparties emerges endogenously. We show that in an equilibrium network the degree of systemic risk, defined as the probability that contagion occurs conditional on one bank failing, is significantly reduced. In certain equilibria, contagion does not occur.

The dynamic properties of micro based stochastic macro models are often analyzed through a linearization around the associated deterministic steady state. Recent literature has investigated the error made by such a deterministic approximation. Complementary to this literature we investigate how the linearization affects the stochastic properties of the original model. We consider a simple real business cycle model with noisy learning by doing. The solution has a stationary distribution that exhibits moment failure and has an unbounded support. The linear approximation, however, yields a stationary distribution with possibly a bounded support and all moments finite.

Financial crises have occurred for many centuries. They are often preceded by a credit boom and a rise in real estate and other asset prices as in the current crisis. They are also often associated with severe disruption in the real economy. This paper surveys the theoretical and empirical literature on crises. The first explanation of banking crises is that they are a panic. The second is that they are part of the business cycle. Modeling crises as a global game allows the two to be unified. With all the liquidity problems in interbank markets that have occurred during the current crisis, there is a growing literature on this topic. Perhaps the most serious market failure associated with crises is contagion and there are many papers on this important topic. The relationship between asset price bubbles, particularly in real estate, and crises is discussed at length.

Modern financial systems exhibit a high degree of interdependence. There are different possible sources of connections between financial institutions, stemming from both the asset and the liability side of their balance sheet. For instance, banks are directly connected through mutual exposures acquired on the interbank market. Likewise, holding similar portfolios or sharing the same mass of depositors creates indirect linkages between financial institutions. Broadly understood as a collection of nodes and links between nodes, networks can be a useful representation of financial systems. By providing means to model the specifics of economic interactions, network analysis can better explain certain economic phenomena. In this paper we argue that the use of network theories can enrich our understanding of financial systems. We review the recent developments in financial networks, highlighting the synergies created from applying network theory to answer financial questions. Further, we propose several directions of research. First, we consider the issue of systemic risk. In this context, two questions arise: how resilient financial networks are to contagion, and how financial institutions form connections when exposed to the risk of contagion. The second issue we consider is how network theory can be used to explain freezes in the interbank market of the type we have observed in August 2007 and subsequently. The third issue is how social networks can improve investment decisions and corporate governance. Recent empirical work has provided some interesting results in this regard. The fourth issue concerns the role of networks in distributing primary issues of securities as, for example, in initial public offerings, or seasoned debt and equity issues. Finally, we consider the role of networks as a form of mutual monitoring as in microfinance.

Banking systems can easily be described by a network, where the links take the form of direct exposures between banks. The same connections that facilitate the transfer of liquidity between banks, expose the banking system to the risk of contagion. That is, idiosyncratic shocks, which initially affect only a few institutions, may propagate through the entire system. This paper studies how the trade-off between the benefits and the costs of being linked changes depending on the network structure. We have shown that incomplete networks give rise to incomplete information. In this situation, the transfers between banks that perfectly ensures against liquidity shocks increase, at the same time, the contagion risk. The problem is solved when the network is complete, as the liquidity can be redistributed in the system, such that the risk of contagion is minimal.

Network formation models arise mainly from two lines of research. One line considers that networks are a consequence of strategic linking behavior of rational agents. The other line assumes that network formation is driven mainly by a stochastic process. While the first approach leads to networks that stylize features like unequal connections and short distances, it is the second that captures richer characteristics of the real-world networks. This paper aims to replicate the predictive power of the second approach in a model where (i) networks expand continuously by the addition of new nodes, (ii) new nodes form links with already existent nodes in order to maximize their payoffs, and (iii) linking requires consent of both agents involved. First, we provide a simple example that explains the emergence of power-law networks when agents entering the network employ logistic choice to form links. Further, we analyze various specifications for the benefits nodes gain from connections, both in a error-free and in a error-prone setting. The key elements that lead to networks with high centrality and many levels of hierarchy are (i) intermediary benefits to those connecting otherwise disconnected parts of the network, and (ii) linking costs that increase with individual degree.