Credit risk transfer and contagion

Some have argued that recent increases in credit risk transfer are desirable because they improve the diversification of risk. Others have suggested that they may be undesirable if they increase the risk of financial crises. Using a model with banking and insurance sectors, we show that credit risk...

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Bibliographic Details
Published in:Journal of monetary economics 2006, Vol.53 (1), p.89-111
Main Authors: Allen, Franklin, Carletti, Elena
Format: Article
Language:English
Subjects:
Bank operations
Banking
Banking industry
Credit market
Credit risk
Diversification
Economic models
Financial economics
Financial innovation
Financial models
Financial services
Impact analysis
Innovations
Insurance
Insurance industry
Liquidity
Mathematical methods
Monetary economics
Pareto inferior
Risk
Studies
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Summary:Some have argued that recent increases in credit risk transfer are desirable because they improve the diversification of risk. Others have suggested that they may be undesirable if they increase the risk of financial crises. Using a model with banking and insurance sectors, we show that credit risk transfer can be beneficial when banks face uniform demand for liquidity. However, when they face idiosyncratic liquidity risk and hedge this risk in an interbank market, credit risk transfer can be detrimental to welfare. It can lead to contagion between the two sectors and increase the risk of crises.
ISSN:0304-3932
1873-1295
DOI:10.1016/j.jmoneco.2005.10.004