The seminar will be held in the Visitor Centre at 3:15 pm
Adam Zawadowski (Princeton University)
Abstract
Counterparty risk was one of the main reasons cited for government intervention in the crisis of 2008. In my model, the financial system is “entangled” and thus susceptible to counterparty risk because financial institutions hedge risks using a network of bilateral over-the-counter contracts. If market participants have few large counterparties, they choose not to insure against a low-probability counterparty default, even if insurance would be socially optimal. Thus the collapse of a single market can lead to a complete collapse of the financial system. Contagion spreads solely through the loss of hedging contracts: there are no direct credit exposures between participants. I show that even though the sparse network structure of hedging contracts is central to the externality, participants are not willing to diversify if that is costly to do. I show that inefficiency is most likely in the early stages of the development of bilateral hedging contracts. The model implies that in case of inefficiency, regulatory intervention making insurance against counterparty risk mandatory, e.g. through a well capitalized clearinghouse, is welfare improving.