The Lehman Brothers' bankruptcy triggered the failure of the collateralized debt markets, which was a major contributor of the financial crisis in 2008. Such collateralized debt markets have both collateral price channel and counterparty (borrower and lender) channel of contagion. I propose a general equilibrium network model, which incorporates the two channels of contagion by endogenizing leverage (margin), asset prices, and network formation. Agents face a tradeoff between leverage and counterparty risk. Diversification of counterparty risk generates positive externalities by reducing systemic risk, but comes at the cost of lower leverage. Thus, any decentralized equilibrium is inefficient due to under-diversification. I use this framework to show that the loss coverage by a central counterparty (CCP) exacerbates the externality problem and the introduction of CCP can rather increase systemic risk.

The Lehman Brothers' bankruptcy triggered the failure of the collateralized debt markets, which was a major contributor of the financial crisis in 2008. Such collateralized debt markets have both collateral price channel and counterparty (borrower and lender) channel of contagion. I propose a general equilibrium network model, which incorporates the two channels of contagion by endogenizing leverage (margin), asset prices, and network formation. Agents face a tradeoff between leverage and counterparty risk. Diversification of counterparty risk generates positive externalities by reducing systemic risk, but comes at the cost of lower leverage. Thus, any decentralized equilibrium is inefficient due to under-diversification. I use this framework to show that the loss coverage by a central counterparty (CCP) exacerbates the externality problem and the introduction of CCP can rather increase systemic risk.

The coronavirus outbreak raises the question of how central bank liquidity support affects financial stability and promotes economic recovery. Using newly assembled data on cross-county flu mortality rates and state-charter bank balance sheets in New York, we investigate the effects of the 1918 Influenza Pandemic on the banking system and the role of the Federal Reserve during the pandemic. We find that banks located in more severely affected areas experienced deposit withdrawals. Banks which were members of the Federal Reserve were able to access central bank liquidity and so continue or even expand lending. Banks which were not members, however, did not borrow on the interbank market but rather curtailed lending, suggesting there was little-to-no pass-through of central bank liquidity. Further, in the counties most affected by the 1918 Influenza, even banks with direct access to the discount window liquidated assets so as to meet large deposit withdrawals, suggesting limits to the effectiveness of the liquidity provision by the Federal Reserve. Finally, we show that the pandemic caused only a short-term disruption on the financial sector. Over the long-term, deposits returned and banks restored their asset portfolios.