Working Paper: NBER ID: w29632
Abstract: The modern financial system features complicated financial intermediation chains, with each layer performing a certain degree of credit/maturity transformation. We develop a dynamic model in which an entrepreneur borrows from overlapping-generation households via layers of funds, forming a credit chain. Each intermediary fund in the chain faces rollover risks from its lenders, and the optimal debt contracts among layers are time invariant and layer independent. The model delivers new insights regarding the benefits of intermediation via layers: the chain structure insulates interim negative fundamental shocks and protects the underlying cash flows from being discounted heavily during bad times, resulting in a greater borrowing capacity. We show that the equilibrium chain length minimizes the run risk for any given contract and find that restricting credit chain length can improve total welfare once the available funding from households has been endogenized.
Keywords: credit chains; financial intermediation; shadow banking; securitization
JEL Codes: D85; E44; E51; G21; G23; G33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| structure of credit chains (E51) | insulates interim negative fundamental shocks (E32) |
| credit chains (E42) | protects underlying cash flows from heavy discounts (G19) |
| credit chains (E42) | reduces liquidation losses (G33) |
| equilibrium chain length (D50) | minimizes run risks (E44) |
| chain length (E42) | total welfare (D69) |
| restricting credit chain length (E51) | improves total welfare (D69) |
| chain length (E42) | borrowing capacity (H74) |