DP16458 Counterparty Choice, Bank Interconnectedness, and Systemic Risk

Author(s): Andrew Ellul, Dasol Kim
Publication Date: August 2021
Keyword(s): Bank interconnectedness, Counterparty Risk, Derivatives, Financial Networks, Over-the-counter markets
JEL(s): D82, G21, G22
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=16458

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.