publication . Article . Preprint . 2017

Correlated Default and Financial Intermediation

Gregory Phelan;
Open Access
  • Published: 13 Apr 2017 Journal: The Journal of Finance, volume 72, pages 1,253-1,284 (issn: 0022-1082, Copyright policy)
  • Publisher: Wiley
Financial intermediation naturally arises when knowledge about the aggregate state is valuable for managing investments and lenders cannot easily observe the aggregate state. I show this using a costly enforcement model in which lenders need ex-post incentives to enforce payments from defaulted loans and borrowers' payoffs are correlated. When projects have correlated outcomes, learning the state of one project (via enforcement) provides information about the states of other projects. A large, correlated portfolio provides ex-post incentives for enforcement; as a result, intermediation dominates direct lending, intermediaries are financed with risk-free deposits...
free text keywords: Economics and Econometrics, Accounting, Finance, Financial intermediation, systemic risk, default, Financial intermediary, Financial system, Intermediary, Enforcement, Portfolio, Intermediation, Systemic risk, Economics, Default, Incentive
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