Counterparty Choice, Bank Interconnectedness, and Systemic Risk" with Dasol Kim (Office of Financial Research)

Abstract:

We provide evidence on how banks form connections when exposed to contagion risk in networks and endogenous risk-taking in their counterparty choices. We use confidential bank 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 with non-bank counterparties that already have a large number of connections with other banks. Banks in such densely-connected networks are more likely to choose riskier counterparties, consistent with moral hazard behavior in networks. Finally, we find evidence that bank-level OTC interconnectedness is consequential for trading desk outcomes. Overall these results are consistent with a network formation process that amplifies risk propagation through material counterparty exposures rather than a risk-sharing mechanism.