Entangled Financial Systems

I model an entangled financial system in which banks hedge their portfolio risks using over-the-counter (OTC) contracts. However, banks choose not to hedge counterparty risk, and thus the idiosyncratic failure of a bank can lead to a systemic run of lenders. An inefficiency arises because banks engage in a version of risk shifting through the network externalities created by OTC contracts. Banks do not take into account that the costly hedging of low-probability counterparty risk also benefits other banks. In the model, it is welfare improving to tax OTC contracts to finance a bailout fund.