Intermediation via Credit Chains

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. The model delivers new insights regarding the benefits of intermediation via layers: by shortening the maturity of liquidated assets, the chain structure insulates interim negative fundamental shocks and protects the underlying cash flows from being discounted heavily during bad times, resulting in a greater borrowing capacity. We show that the equilibrium chain length minimizes the run risk and that it is constrained efficient.