Published: July 12, 2021
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).
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