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Financial Connections and Systemic Risk

In: Market Institutions and Financial Market Risk

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  • Franklin Allen
  • Ana Babus
  • Elena Carletti

Abstract

We develop a model where institutions form connections through swaps of projects in order to diversify their individual risk. These connections lead to two different network structures. In a clustered network groups of financial institutions hold identical portfolios and default together. In an unclustered network defaults are more dispersed. With long term finance welfare is the same in both networks. In contrast, when short term finance is used, the network structure matters. Upon the arrival of a signal about banks' future defaults, investors update their expectations of bank solvency. If their expectations are low, they do not roll over the debt and there is systemic risk in that all institutions are early liquidated. We compare investors' rollover decisions and welfare in the two networks.

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This chapter was published in:

  • Mark Carey & Anil Kashyap & Raghuram Rajan & RenĂ© Stulz, 2012. "Market Institutions and Financial Market Risk," NBER Books, National Bureau of Economic Research, Inc, number care10-1, octubre-d.
    This item is provided by National Bureau of Economic Research, Inc in its series NBER Chapters with number 13175.

    Handle: RePEc:nbr:nberch:13175

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    1. Xavier Freixas & Bruno Parigi & Jean Charles Rochet, 1998. "Systemic risk, interbank relations and liquidity provision by the Central Bank," Economics Working Papers 440, Department of Economics and Business, Universitat Pompeu Fabra, revised Sep 1999.
    2. Matthew O. Jackson & Asher Wolinsky, 1994. "A Strategic Model of Social and Economic Networks," Discussion Papers 1098, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
    3. Franklin Allen & Ana Babus & Elena Carletti, 2009. "Financial Crises: Theory and Evidence," Annual Review of Financial Economics, Annual Reviews, vol. 1(1), pages 97-116, November.
    4. Carmen M. Reinhart & Kenneth S. Rogoff, 2009. "This Time Is Different: Eight Centuries of Financial Folly," Economics Books, Princeton University Press, edition 1, volume 1, number 8973.
    5. Diamond, Douglas W, 1991. "Debt Maturity Structure and Liquidity Risk," The Quarterly Journal of Economics, MIT Press, vol. 106(3), pages 709-37, August.
    6. Douglas W. Diamond & Raghuram G. Rajan, 1999. "Liquidity Risk, Liquidity Creation and Financial Fragility: A Theory of Banking," NBER Working Papers 7430, National Bureau of Economic Research, Inc.
    7. Wagner, Wolf, 2010. "Diversification at financial institutions and systemic crises," Journal of Financial Intermediation, Elsevier, vol. 19(3), pages 373-386, July.
    8. Castiglionesi, F. & Navarro, N., 2007. "Optimal Fragile Financial Networks," Discussion Paper 2007-100, Tilburg University, Center for Economic Research.
    9. Richard J. Herring & Susan Wachter, 1999. "Real Estate Booms and Banking Busts: An International Perspective," Center for Financial Institutions Working Papers 99-27, Wharton School Center for Financial Institutions, University of Pennsylvania.
    10. Nicole M. Boyson & Christof W. Stahel & Rene M. Stulz, 2008. "Hedge Fund Contagion and Liquidity," NBER Working Papers 14068, National Bureau of Economic Research, Inc.
    11. Calomiris, Charles W & Kahn, Charles M, 1991. "The Role of Demandable Debt in Structuring Optimal Banking Arrangements," American Economic Review, American Economic Association, vol. 81(3), pages 497-513, June.
    12. Flannery, Mark J, 1986. " Asymmetric Information and Risky Debt Maturity Choice," Journal of Finance, American Finance Association, vol. 41(1), pages 19-37, March.
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