Counterparty Choice, Bank Interconnectedness, and Systemic Risk

Dense linkages between banks and nonbanks in the financial network can create and amplify contagion risks. This paper uses regulatory data to provide evidence of systemic risk-shifting in banks through their choices of nonbank counterparties in the over-the-counter derivative markets. Additionally, banks’ joint exposures to the same counterparties, particularly nonbank financial ones, are strongly associated with systemic risk (Working Paper no. 21-03).

Abstract

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.

Keywords: counterparty risk; financial networks; bank interconnectedness; over-the-counter markets; derivatives
JEL Classifications: G21, G22, D82