The Anatomy of Financial Exposures

Abstract: Financial stability depends on the network of financial exposures. Even though its anatomy is usually taken as exogenous, it reacts not only to changes in the environment but also to changes in regulations introduced to tame financial fragility.  We construct a model with heterogenous banks that choose how much to insure through derivative contracts and whether to be exposed to a centralized (CCP) or bilateral (OTC) counterpart, weighing the collateral and transparency costs of these choices. By modeling the optimal decisions of atomistic members of finite banks, we use a network taking approach that bypasses strategic considerations and allows us to simultaneously capture optimal contracts and the endogenous network of financial exposures among banks. We characterize how the equilibrium network of financial exposures changes with capital requirement regulations, and how regulations may backfire if not taking this endogenous reaction into account.