Research / BFI Working PaperNov 10, 2021

Intermediation via Credit Chains

Zhiguo He, Jian Li

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 real project from being liquidated in 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.

More Research From These Scholars

BFI Working Paper Mar 1, 2019

Leverage-Induced Fire Sales and Stock Market Crashes

Jiangze Bian, Zhiguo He, Kelly Shue, Hao Zhou
Topics:  COVID-19