Correlated Default and Financial Intermediation

  • Author(s): GREGORY PHELAN
  • Published: Apr 13, 2017
  • DOI: 10.1111/jofi.12493

ABSTRACT

Financial intermediation naturally arises when knowing how loan payoffs are correlated is valuable for managing investments but lenders cannot easily observe that relationship. I show this result using a costly enforcement model in which lenders need ex post incentives to enforce payments from defaulted loans and borrowers' payoffs are correlated. When projects have correlated outcomes, learning the state of one project (via enforcement) provides information about the states of other projects. A large correlated portfolio provides ex post incentives for enforcement. Thus, intermediation dominates direct lending, and intermediaries are financed with risk‐free deposits, earn positive profits, and hold systemic default risk.

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