OFR – Issued paper on counterparty choice and systemic risk

July 13, 2021 -Uses capital assessments and stress testing reports over the period 2013-2020, to empirically investigate how banks choose (mostly) non-bank counterparties to link to. Informs channels through which counterparty leverage can accumulate in opaque= financial markets through derivative positions of non-bank counterparties.

Paper Overview
Paper uses regulatory data to provide evidence of systemic risk-shifting in banks via their choices of nonbank counterparties in the over-the-counter derivative markets. Showed that banks prefer to establish and maintain relationships with non-bank counterparties that have a larger set of connections with other banks and are already heavily exposed to those banks, leading to a more densely connected network. Banks in densely connected networks are more likely to connect with riskier counterparties for most material exposures and effects strongest in the case of non-bank counterparties. These findings suggest moral hazard behavior in counterparty choices. Exposures are strongly linked to systemic risk; results suggest a network formation process that amplifies risk propagation via non-bank linkages in opaque financial markets. A more densely connected network provides the benefit of co-insurance in the case of a shock but also the cost that banks will have the incentive to take on greater risk.

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