When Choosing Counterparties, Banks Tend to Pick Riskier Ones

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When Choosing Counterparties, Banks Tend to Pick Riskier Ones

In a recent working paper analyzing who banks chose as counterparties in the over-the-counter (OTC) derivatives market, the authors found that banks are more likely to choose riskier nonbank counterparties that are already heavily connected and exposed to other banks, which leads to an even more densely connected network.  Furthermore, banks do not hedge these exposures, but rather increase them by selling rather than purchasing credit derivative swaps against these counterparties.  Finally, the authors found that common counterparty exposures are correlated with systemic risk measures despite greater regulatory oversight following the 2008 financial crisis.

What are the primary conclusions?

The authors looked at risk-taking by banks as demonstrated by choice of their nonbank counterparties.  The analysis focused on how these choices in the OTC derivative markets contribute to network fragility.  The authors found:

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